What is a cash balance pension scheme and how does it differ from a normal defined benefit or defined contribution pension?

Full answer

Cash balance schemes sit in a middle ground between traditional defined benefit and defined contribution pensions, and because they are relatively uncommon compared with the two more familiar structures, members often benefit from understanding exactly how their specific promise works. **How cash balance differs from traditional defined benefit** A traditional final salary or career average defined benefit scheme promises a specific ANNUAL PENSION INCOME in retirement, calculated by a formula linked to salary and years of service (for example, 1/60th of final salary for each year worked) -- the employer bears the investment and longevity risk of delivering that promised income. A cash balance scheme, by contrast, promises to build up a specific CASH LUMP SUM (often expressed as a percentage of salary credited to a notional account each year, sometimes with a guaranteed minimum interest/growth rate applied to the accumulating balance) rather than directly promising an ongoing income figure -- the employer's guarantee is on the SIZE OF THE LUMP SUM, not on what specific retirement income that lump sum will ultimately buy. **How cash balance differs from defined contribution** In an ordinary defined contribution scheme (like a typical workplace pension or SIPP), the member bears the full investment risk -- contributions are invested, and the eventual pot size depends entirely on actual investment performance, with no employer guarantee about the minimum value. In a cash balance scheme, the employer typically guarantees a MINIMUM growth rate (or a fixed formula-based credit) on the notional cash balance, shifting at least some investment risk back onto the employer compared with a pure defined contribuiton arrangement, even though the ultimate promise (a cash sum, not an income) resembles defined contribution more than traditional defined benefit. **What happens at retirement** Once a member reaches retirement, the accumulated cash balance is typically used in a similar way to a defined contribution pot -- it can be used to purchase an annuity, moved into drawdown, or taken as a combination of tax-free lump sum and taxable withdrawals, subject to the normal pension access rules that apply to any money purchase-style pension benefit at the point of taking it. **Why some employers use cash balance schemes** Cash balance schemes have sometimes been used by employers wanting to offer a more valuable, guaranteed-feeling benefit than a pure defined contribution scheme (helping with recruitment and retention), while avoiding the potentially very large and unpredictable long-term liabilities associated with a traditional defined benefit final salary promise, which can be heavily affected by uncertain future investment returns, inflation, and increasing life expectancy assumptions. **Tax treatment** For pension tax purposes (annual allowance, tax relief on contributions, and the Lump Sum Allowance/Lump Sum and Death Benefit Allowance following LTA abolition), a cash balance scheme is generally treated broadly similarly to other registered pension schemes, though the specific method for valuing the annual "pension input amount" against the Annual Allowance can follow defined-benefit-style valuation methods (given the notional guaranteed credit structure) rather than simply looking at contributions paid in, so specific scheme rules and actuarial guidance may be needed to calculate this accurately for high earners near the Annual Allowance limit. **Worked example** An employee's cash balance scheme credits 20% of their annual salary to a notional account each year, with a guaranteed minimum annual growth rate of 3% applied to the accumulating balance regardless of how the scheme's actual underlying investments perform. After 20 years of service on a broadly stable salary, this builds up to a specific guaranteed cash lump sum at retirement (higher than a straightforward defined contribution scheme would guarantee, since the employer bears the risk of at least matching that 3% minimum growth rate even in a poor investment period) -- the employee then uses this lump sum to access their pension via drawdown or an annuity, exactly as they would with money accumulated in an ordinary defined contribution pension pot. **Practical tip** Members of a cash balance scheme should specifically check their scheme's benefit statement to understand the exact formula used to build up their notional cash balance (including any guaranteed minimum growth rate) and how the Annual Allowance impact of their scheme membership is calculated, since this can be more complex to interpret than a simple defined contribution statement showing just contributions paid in and current fund value.

Try the calculator