Higher tax rates have increased the popularity of cash balance plans for professional practices and small businesses. Could you benefit from greater tax-deferred savings growth?
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This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. Bernstein does not provide tax, legal, or accounting advice.
A cash balance plan is a defined-benefit pension plan that has features similar to a defined-contribution plan. Participants have an individual account balance, which they can roll into an IRA when they turn 59 1/2, leave the firm, or if the plan is terminated.
Typically, businesses that already have an existing 401(k) or profit-sharing plan and staff-to-owners ratio of less than 10 to one are good candidates for cash balance plans.
To establish the plan, the professional practice or small business engages an actuary to determine how much the partners/owners could defer for a given level of contributions to the staff.
A cash balance retirement plan offers several benefits, including:
Cash balance retirement plans tend to appeal to firms that have:
Plan sponsors face some thorny challenges in today’s investment environment. Rising interest rates, inflation, and equity market volatility are conspiring to introduce hidden risks into seemingly conservative cash balance retirement plans. Our specialists can review your plan, helping to ensure you’re positioned for today’s investment landscape.
The asset allocation for a cash balance plan must be carefully constructed to balance the desire for growth with the need for protection against loss. We can help you manage the risks.
Most cash balance retirement plans share a similar profile when it comes to investing goals. For instance, plan assets are pooled and typically invested with the goal of matching the target rate of return.
The target return can vary by plan design and demographics, but most cash balance plans have a return goal between 1% and 6%, with many plans targeting around 4%.
Exceeding or falling short of the target return can cause over- or underfunding issues that plan sponsors would rather avoid. That’s one of the reasons why most plans traditionally invest in bond-dominated portfolios.
The chief benefit is not the modest return earned in the plan—it’s the ability to defer substantially more income that can eventually be rolled over for additional future tax-deferred or tax-free growth.
Doubling dollars in a retirement plan like a cash balance plan doesn’t translate directly into a doubled amount of sustainable spending. That’s because the value of a dollar saved in a tax-deferred retirement plan varies significantly based on the age of the participant at the time of the contribution.
Given the longer period available for tax-deferred growth, contributions at an early age have a greater relative value compared to those made later in life. Nevertheless, investing in tax-deferred assets can help you to catch up if you start later.
For instance, for someone who plans to begin spending at age 65, investing in a tax-deferred account at age 35 can provide the same sustainable spending as saving equivalent amounts in a taxable account at age 25. In other words, the tax deferral can turn back the savings clock by a full 10 years.
This effect is particularly noteworthy for business owners and professionals who may have spent their early careers reinvesting in their companies or paying off costly student loans. The ability to put more money away tax-deferred can help the owner recoup some of the advantage of early savings.
