One of the greatest rewards for a life of hard work is financial security in retirement. So, when it comes to attracting, retaining, and rewarding key employees, retirement savings plans can be a differentiator. What options exist to supplement a 401(k)’s annual contribution limits? Cash balance pensions or a nonqualified retirement plan could be a difference maker.

Since its arrival on the scene in the late 1970s, the 401(k) has become the standard for retirement savings with more Americans participating in one than any other type of retirement savings account, according to U.S. Census Bureau data. They’re easy to use and tax advantaged, making them great savings tools for most people. But limits to annual contributions mean they may not be most effective as a standalone vehicle for high-earners or other key employees.

“Nearly everyone can benefit from a 401(k) regardless of tenure, role, or level of compensation, but they may not be a competitive differentiator for certain employees who might need a supplemental solution or plan with more flexibility,” said Christopher Dall, Managing Director, Retirement Solutions at PNC Institutional Asset Management.

Qualified vs. Nonqualified plans

That flexibility may be found in a non-qualified retirement plan. Retirement plans are classified as either qualified or non-qualified. Qualified retirement plans — such as a 401(k) — meet requirements of the Employee Retirement Income Security Act of 1974 (ERISA) around broad plan eligibility and participation. Plan sponsors and participants are subsequently entitled to various tax advantages and fund protections based on the specific type of plan.

Nonqualified plans — such as a deferred compensation or executive bonus plan — have more flexibility in structure and are generally not bound by the IRS and ERISA requirements, but also do not receive the same protections.   

Nonqualified plans have no limits on contributions and because they aren’t subject to ERISA regulations, do not need to be made available to all employees. They are generally only offered to select high-earning employees as an unrestricted supplemental savings vehicle to a 401(k). Primary benefits of a nonqualified plan include:

  • No annual contribution limits;
  • No required ERISA discrimination testing, as with a qualified retirement plan;
  • Benefits to employees are taxed when they are paid, when the beneficiary is presumably in a lower tax bracket; and
  • Customizable to meet the employee’s or sponsor’s unique needs.

The primary drawback to nonqualified plans is that, while they are not subject to the discrimination testing requirements of ERISA, they are also not afforded ERISA’s protections. Funds in a nonqualified plan are not necessarily guaranteed and are subject to creditors in the event the plan sponsor experiences financial troubles. Nonqualified plans may also be comprised of after-tax contributions, unlike many qualified retirement plans.

“Setting up a deferred compensation plan or other nonqualified structure can be an effective tool because the terms can be customized and allow for significant supplemental savings for high earners,” Dall said. “Especially when there’s confidence in the financial stability of the plan sponsor, nonqualified plans can be a real difference maker.” 

Why a cash balance pension?

One alternative to offering a nonqualified plan is the cash balance pension. A cash balance pension is a defined benefit plan that is managed much like a 401(k) with contributions and interest credits from the plan sponsor. It differs from a standard pension in that instead of a benefit defined by a guaranteed monthly payment in retirement as in a standard pension, in a cash balance plan, the benefit is defined as a guaranteed benefit that looks like an account balance. The plan sponsor is responsible to adequately fund the plan to meet that balance despite any fluctuations in the market. Cash balance pensions are qualified retirement plans, so they are subject to ERISA protections. Key benefits of a cash balance pension include:

  • Guaranteed benefit available as a lump sum or annuity upon distribution;
  • Benefit that is portable in case of termination, plan closure, retirement, or once you reach age 59.5;
  • Benefit that is shielded from potential creditor claims or lawsuits;
  • Tax-deductible contributions for plan sponsors and tax-deferred contributions for recipients; and
  • Larger annual contribution limits than a 401(k).

Like nonqualified plans, distributions from cash balance pension plans are taxable for recipients but can be rolled over to another qualified account such as an IRA or other qualified defined contribution plan to avoid taxable events. Plan sponsors bear any investment risk as well as the responsibility to fulfill the promised benefit for recipients.

“A cash balance pension can be a great recruitment tool to incentivize key employees because they’re tax advantaged are afforded protections through ERISA,” Dall said. “The contribution structure makes them a popular and growing option especially for smaller and mid-sized businesses.”

Attracting, retaining, and incentivizing key employees is critical for businesses of all sizes. With the unique needs of both employees and plan sponsors in mind, a nonqualified plan or cash balance pension can be a difference maker in providing supplemental retirement savings as part of a benefits plan.