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 participant's compensation.
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)
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
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 contribution credits.
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
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
In order to minimize volatility, many plans elect to use the
30-year Treasury rate which has generally remained between 2.5% and 5%
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
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
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
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
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 contributions.
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 benefit formulas.
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.
The information contained in this newsletter is
intended to provide general information on matters of interest in the
area of qualified retirement plans and is distributed with the
understanding that the publisher and distributor are not rendering
legal, tax or other professional advice. You should not act or rely on
any information in this newsletter without first seeking the advice of
a qualified tax advisor such as an attorney or CPA.