Cash balance plans have enjoyed
a recent resurgence in popularity. However, these plans, which can provide
tax-deductible benefits as much as five times greater than 401(k) profit
sharing plans, have actually existed for more than 30 years. When the
Pension Protection Act of 2006 (PPA) resolved much of the legal uncertainty
of these plans, small and large companies alike showed a renewed interest.
According to a recent research report, the number of cash balance plans
increased by more than 23% from 2006 to 2007 and more than 75% of existing
cash balance plans are sponsored by companies with fewer than 50 employees.
What is a Cash Balance Plan?
Before answering this question, some general background information helps
put the discussion in context. A defined contribution (DC) plan, such as a
401(k) profit sharing plan, dictates the contributions that go into the plan
each year. Contributions, which are usually discretionary, include employee
salary deferrals, employer matching contributions and employer profit
sharing contributions. The maximum amount a participant can receive in a DC
plan each year is $49,000 for those under age 50 and $54,500 for those age
50 or older. These contributions and the investment returns they generate
determine a participant's ultimate retirement benefit.
A defined benefit (DB) plan promises a benefit using a formula that is
usually based on compensation and years of service. For example, a DB plan
might provide an annual benefit equal to 1% of average compensation for each
year of service. If a participant has average compensation of $65,000 over
10 years with the company, the annual benefit is equal to $6,500 ($65,000 x
1% x 10 years of service) for the rest of the participant’s life.
Rather than limiting contributions, the IRS limits the maximum annual
benefit a DB plan can provide to a participant to $195,000 per year. The
contribution is a function of how much is needed to fund the promised
benefits. While there are a number of variables, the following table
summarizes the tax-deductible contributions to fund maximum benefits for DB
participants of different ages:
The employer is said to bear the investment risk because the higher the
return on investment, the lower the portion of the funding that must come
from the company and vice versa. To the extent a DB plan is not fully
funded, contributions are generally required each year.
A cash balance plan is a type of plan that is sometimes referred to as a
hybrid plan, because it includes both DB and DC characteristics. Cash
balance plans generally express benefits in the form of contributions much
like a DC plan while requiring regular funding of those promised benefits
like a DB plan.
Unlike traditional DB plans that express benefits using a formula that
can appear esoteric to the average employee, cash balance plans express
benefits using specific contribution crediting rates that could be
percentages or flat dollar amounts. For example, the plan might provide for
an annual contribution credit equal to $1,000 per participant or 5% of each
Similar to a new comparability, i.e. cross-tested, profit sharing plan, a
cash balance plan may provide different levels of benefit to different
employees. A typical design might provide $100,000 per year to owners and 5%
of compensation to employees. Keep in mind that the plan's benefits must
satisfy nondiscrimination testing, so what works in one situation will not
necessarily work in all situations.
The contribution credit is added to a notional or hypothetical account
for each participant, and he can look at a benefit statement to see the
incremental increase each year similar to a 401(k) statement.
The interest crediting rate is the rate at which the plan guarantees
interest on the accumulated contribution credits. The interest is added to
each participant’s hypothetical account just like the contribution credits.
Sounds simple, right? Believe it or not, there are hundreds of pages of
regulations detailing how cash balance plans can and cannot establish
interest crediting rates. In a nutshell, these regulations mandate that
plans can only use a “market rate of return.” Examples of market rates
include the 30-year Treasury rate; the interest rate on long-term,
investment-grade bonds; a stock market index such as the S&P 500; or the
actual rate of return of the plan’s investments.
Selecting a rate for a plan is often an issue of risk tolerance. The
higher the crediting rate, the higher the benefit over time; however, since
the rate must be guaranteed, a higher rate also means higher risk in the
event the actual investments do not achieve the guarantee.
One common question is whether losses can be credited if the market rate
the plan uses is negative. The answer is “it depends.” A plan can credit
investment losses to hypothetical accounts, subject to the “preservation of
capital rule.” This rule provides that crediting losses cannot reduce a
participant’s hypothetical account to an amount less than the sum of all
Example: Russell is a participant in a cash balance plan that provides
annual contribution credits equal to 5% of compensation and interest credits
equal to the S&P 500 annual return.
|S&P 500 Annual Return
Russell’s benefits over this two-year period would be reflected as
| Contribution Credit
Note that 2008’s interest crediting rate of -37% actually yields a loss
of $2,183 ($5,900 x -37%). However, the preservation of capital rule only
permits the plan to allocate a loss of $150 in order for Russell's benefit
to remain no less than the sum of his contribution credits.
In order to minimize volatility, many plans elect to use the 30-year
Treasury rate which has generally remained between 2.5% and 5% since 2008.
Vesting and Payment of Benefits
PPA requires that cash balance plans provide full vesting after
completion of no more than three years of service, so the six-year graded
schedule that is common in 401(k) profit sharing plans cannot be utilized.
Since cash balance plans are DB plans, they are required to offer joint and
survivor annuities as the default form of benefit payment; however, they can
also allow participants to take lump sum distributions.
Whereas traditional DB plans require a number of complex calculations to
determine the lump sum equivalent of an annuity, a participant’s
hypothetical account balance in a cash balance plan is deemed to be the lump
sum amount. Cash balance plans are also permitted to offer in-service
distributions when a participant reaches age 62 or older.
The plan’s actuary calculates the required funding based on a number of
factors including the amount of the promised benefits that have accumulated
for all participants, each participant’s proximity to retirement age and
participant life expectancy.
Let’s go back to our friend Russell and assume he is 30 years old at the
end of 2008. The actuary must calculate what Russell’s $5,750 hypothetical
account will be worth 35 years later when he reaches the plan’s retirement
age of 65. Let’s assume that projected value is $28,000. The actuary must
then determine how much the employer must contribute now in order to ensure
there is $28,000 available to cover Russell’s future benefit. This process
is repeated to arrive at an aggregate funding requirement for the plan based
on all the variables for all plan participants.
The funding level the actuary calculates is compared to the actual assets
in the plan to determine how much more the employer must contribute to keep
the plan fully funded. The higher the plan’s funding level, the lower the
required contribution; and the lower the plan's funding level, the higher
the required contribution. Thus, the required contribution for any given
year is not necessarily equal to the sum of the contribution credits and the
interest credits for that year, and the amount contributed is not earmarked
to fund benefits for any specific participant. Rather, it is applied to
increase the funded status of the entire plan.
In order to provide added security to the retirement benefits promised by
these plans, the PPA established more strict funding requirements. Plans for
which the ratio of actual to required funding falls below 80% are prohibited
from increasing plan benefits, and the plan’s ability to pay lump sum
distributions to departing participants is restricted. Plans with a funding
ratio below 60% must freeze future benefits and the ability to make lump sum
payments is eliminated.
While it might seem obvious that an underfunded plan should freeze future
benefits, employers can find themselves in an unenviable position when they
must tell former employees seeking benefit distributions that they cannot
receive their full benefit due to a funding problem.
While most DC plans allow participants to direct the investment of their
own accounts, all of the assets in a cash balance plan are generally
maintained in a pooled account and invested by the plan trustee(s) or a
professional investment manager. Since the plan sponsor must guarantee
benefits regardless of the actual return on investment, a disciplined
investment strategy is necessary. Some will seek to exactly mirror the
plan’s interest crediting rate so that the plan’s investments are generating
the exact amount of income needed. Others will seek to generate slightly
higher returns to improve the plan’s funding ratio and reduce the amount the
employer must contribute.
It is suggested that the plan sponsor work together with the actuary and
investment manager to determine the most appropriate strategy given the plan
design and the sponsor’s risk tolerance and cash flow.
There are several additional points worth noting. First is that like
other qualified retirement plans, the assets held in a cash balance plan are
protected from the plan sponsor’s creditors and legal judgments. This may be
particularly advantageous for business owners in higher-risk occupations.
Second, all types of defined benefit plans are generally required to
purchase coverage from the Pension Benefit Guaranty Corporation (PBGC). The
PBGC insures a portion of the plan’s promised benefits in the event the
sponsor becomes insolvent and is unable to satisfy its funding obligation.
Certain types of employers such as professional organizations, e.g. doctors
and attorneys, with fewer than 25 employees are exempt from coverage. While
there are a number of factors that impact the cost of PBGC coverage, the
flat rate premium is generally $35 per participant.
Is a Cash Balance Plan Right For You?
Cash balance plans are powerful tools that can address a variety of
planning needs from tax and retirement planning to estate and business
succession planning. One of the most important requirements is consistent
cash flow. Since annual contributions are generally required, a business
that has irregular cash flow could have trouble meeting its funding
obligations during slower years, leading to benefit restrictions and excise
taxes. In addition, the annual costs of maintaining the plan are typically
paid by the plan sponsor and not from the plan itself since any reductions
in plan assets will reduce the funded status and require additional
To maximize the ability to provide greater benefits to a company’s key
employees, cash balance plans are usually used in conjunction with 401(k)
profit sharing plans. However, the stability of the demographic make-up of
the workforce is an important variable to be considered when designing the
Companies considering cash balance plans should work with qualified,
experienced professionals who can discuss the pros and cons and tailor a
plan design to meet their goals.
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