Originally published in Denver Business Journal

By Paula Hendrickson

Successful professionals and business owners worry about retirement savings, just like everyone else these days. Do they have enough socked away? Could taxes, inflation and healthcare costs rise and nibble away at their savings? What about new regulations and legislation?

That’s why many high-earners are increasingly turning to little-known cash balance defined benefit plans, which are similar to old-fashioned pensions but have some 401(k) twists.

These plans allow business owners to save up to $228,000 a year tax-deferred and $2.6 million over a lifetime. They can also be a reward for key employees.

Surprisingly, many retirement advisors are not aware of these plans, while others have steered clear due to their complexity. Confusion about cash balance plans is common, however, particularly in how they differ from 401(k)s and plain-vanilla pensions.

Cash balance plans differ substantially from 401(k)s, which are defined-contribution rather than defined-benefit plans. Defined-contribution plans typically permit participants to direct their own investments and bear the investment risks and rewards. Cash balance plans do not.

The contribution limits also are much lower in a 401(k), but combining a 401(k) plan with a cash balance plan can create tremendous tax savings opportunities.

Both cash balance plans and traditional defined-benefit plans such as pension plans, are structured to make payments for life upon retirement. In traditional plans, however, benefits are presented as a monthly annuity payable at retirement age. Cash balance plans present the benefits as a hypothetical account balance plus a credited interest amount.

In both instances the employer, or a manager hired by the employer, manages both types of plans, and the employer bears the investment risks.

The Pension Benefit Guaranty Corporation, a quasi-governmental agency, can assume trusteeship of both cash balance and traditional defined-benefit plans and pay benefits, with some limitations, in the event of a termination.

Both types of plans may pay distributions as an annuity or as a lump sum, which can be rolled into an IRA or a new employer’s retirement plan.

The number of cash balance plans increased 22 percent nationally in 2012, the most recent year for which data is available, versus a 1 percent increase in 401(k) plans and a decline in traditional defined-benefit plans. They made up 25 percent of all defined-benefit plans in 2012, up from 2.9 percent in 2001, according to a Kravitz report.

This growth has come predominately from small and mid-size businesses, those with 100 employees or fewer, and mostly those with 25 employees or fewer.

Some employers find that their workforce demographics, from a pension perspective, make cash balance plans attractive; the ideal employer has a few older, high-paid owners or key employees and a staff of mostly lower-earning younger workers.

Why? Cash balance plans must ensure proportionate benefits are provided to all plan participants. The benefit calculations are based upon a number of factors, including years until retirement, annual earnings and an assumed interest credit. The younger the average age of the non-key employee group, the lower the contribution needed (due to the time-value of money). A company with younger key employees may face challenges getting the most benefit from a cash balance pension plan.

Demographics are part of the reason medical practices have been attracted to cash benefit plans. Many physicians also want to contribute as much as they can as quickly as they can because they wish to retire before 65. Others seek to sell their businesses in the face of compensation changes from the Affordable Care Act.

One thing all employers should consider is that cash balance plans are expensive to set up and administer, in part because of the cost of administration and employing an actuary to certify the valuation annually. Moreover, some employers are subject to annual premium costs paid to the Pension Benefit Guaranty Corporation.

They should be aware, too, of market volatility. For example, if a plan does not achieve its targeted return, the employer is liable for any shortfall that results. Conversely, if the plan outperforms, it could become overfunded and reduce the amount employers can contribute. It is a balancing act and requires an understanding of pension regulations.

While market volatility is a consideration, cash balance plans have a significant advantage over traditional defined benefit plans. Because cash balance plans are tied to interest rates, such as the 30 year Treasury or a fixed rate, the returns are typically much more predictable and less risky than traditional defined benefit plans, giving business owners greater peace of mind with these plans – in addition to tax and savings incentives.

Paula Hendrickson is director of retirement consulting services at First Western Trust in Denver. She can be reached at 303-634-2721 or via email at Paula.Hendrickson@myfw.com.