Cash balance is a viable option for pensions

July 1, 2006

A urologist from another practice mentioned that his practice has made some changes in its retirement plan to create greater benefits for the doctors. He thought the new plan was called a "cash balance plan." Does this really work?

A. There are generally two different types of pension plans: defined contribution and defined benefit. While defined contribution plans focus on the maximum allowable amount of contributions to be made by the employer for the benefit of an employee, defined benefit pension plans provide for a specific benefit at retirement for each eligible employee.

When a participant becomes entitled to receive benefits under a cash balance plan, the benefits received are defined in terms of an account balance. As an example, in the case of a physician participant with an account balance of $1 million at age 65, he can decide to receive benefits in the form of an annuity, where he may receive a fixed dollar amount over his lifetime. If structured properly by the TPA, the participant may also be able to take a lump-sum benefit of the $1 million, and may either pay the current tax liability or rollover the funds on a tax-free basis into an individual retirement account. Some plans also allow the rollover of any vested benefit if the employee terminates employment prior to the "normal" retirement age.

Both traditional defined benefit plans and cash balance plans are required to offer payment of an employee's benefit in the form of a series of payments over a lifetime, commonly know as annuity payments. Traditional defined benefit plans quantify an employee's benefit as a series of monthly payments for life to begin at a stated retirement age. Cash balance plans, on the other hand, quantify or define the future retirement benefit in terms of a stated total account balance.

One of the most popular retirement plans utilized by medical practices is the 401(k) plan, which is a type of defined contribution plan. The cash balance plan differs from the 401(k) plan because it is considered to be technically a "defined benefit" plan. Participation in the cash balance plan is not dependent on the employee contributing part of his compensation, on his own behalf, into the plan. With a 401(k) plan, participation is dependent on an employee choosing to make contributions to the plan.

Another major difference deals with inherent investment risk. The investments of cash balance plans are managed by the employer or an investment adviser retained by the employer. The employer would bear the risks as well as the rewards of the investment plan's performance. Increases and decreases in the value of the investments do not directly affect the benefit amounts that were promised to the participants. With a standard 401(k) plan, many plans offer the opportunity for participants to direct their own investments. Employees bear the investment risks as well as the potential benefits associated with investing.