Cash Balance Retirement Plans: An Introduction

Posted on December 01, 2009

What is a cash balance plan?

A cash balance plan is a type of defined benefit pension plan. In a defined benefit plan, the employer assumes the obligation to contribute the amounts necessary so the retirement trust accumulates sufficient funds to pay the promised benefit (regardless of the investment performance of the trust). A traditional defined benefit plan defines a participant’s benefit on the basis of either a fixed dollar amount or percentage of average (or final average) compensation and years of service. A cash balance plan, on the other hand, states a participant’s benefit as a current lump sum or cash balance. The benefit is not an individual account, but only a recordkeeping entry used to identify each participant’s benefit under the plan and to effectively communicate the value of the benefit to participants.

How is the benefit or the cash balance determined?

For a new plan or a new employee, the beginning balance is zero. Each year the account is credited with an annual contribution credit (usually based on a percentage of compensation) and an interest credit. For example, assume the plan provides for an annual credit of 4% of compensation, an interest credit of 5% and a first year participant’s compensation is $50,000. At the beginning of the year, the first year participant’s cash balance account is zero. At the end of year, it is credited with zero interest ($0 x 5% = $0) and a credit of $2,000 (4% x $50,000). At the end of year 2, this participant’s cash balance benefit would be $4,100 [previous balance ($2,000) + the interest factor (5% x $2,000) + contribution credit (4% x $50,000)].

What are the advantages of a cash balance design vs. a traditional defined benefit formula?

Although it is a defined benefit plan, and all of the actuarial work of a traditional defined benefit plan is required, a cash balance design has the look and feel of an individual account plan to employees, who can see the value of “their account.” This is more easily understood than a traditional defined benefit that requires the employee to calculate years of credited service, average pay and multiply by a benefit factor. Younger employees and employees who have a shorter work career favor the cash balance design because the benefit is earned on the basis of current compensation and not tied to years of future service.

From the employer/sponsor’s perspective, the ease of communicating the benefit and the immediate benefit for new hires create recruiting advantages. In addition, and perhaps more importantly, the cash balance design allows the employer to minimize the funding volatility (and underfunded liability) associated with traditional defined benefit plans. Benefit formulas based on each year’s compensation minimize the risk associated with actual average pay increases exceeding estimates and the permissible interest rates for cash balance plans are typically tied to bond yields (e.g. long term investment grade bonds or 30-year Treasury rate). These permissible interest rates generally mitigate the risks associated with underfunding in traditional defined benefit plans. Note that the plan’s annual interest rate credit is the rate that is applied to the participant’s recordkeeping account, not necessarily the plan’s rate of return. Since this is not an individual account plan (although it has that look and feel to participants), the trust assets are held and invested by the trustee. The permissible interest crediting rates are generally conservative and allow the employer to invest the trust assets in a corresponding manner, so as to minimize the risk associated with investment volatility.

Who might consider a cash balance plan?

  • An employer who wants a defined benefit plan that is easier to communicate and that may cause less financial statement impact;
  • An employer who sponsors a defined contribution plan but wants a greater contribution;
  • An employer who is older than the general workforce; and
  • An employer who understands that there are higher administrative costs associated with cash balance plans.

Show me!

Employer has one highly compensated employee, the owner [annual compensation $245,000] (HCE) age 55 and 7 employees ages ranging from upper 50’s to late 20’s (NHCEs). The aggregateNHCEs’ compensation is approximately $250,000. The employer already sponsors a profit sharing 401(k) plan from which the HCE’s allocation and elective deferrals (not counting catch-up contributions) total $49,000. HCE would like an annual benefit of $100,000. Because the HCEmakes the maximum annual contribution under the 401(k) plan, other employees are making elective deferrals to that plan and view it very favorably, there is no desire to terminate the 401(k) plan.

A cash balance plan could provide a benefit level for the HCE at 20% of compensation and a benefit level for the NHCEs at 2% of compensation. This would provide the HCE with an annual cash balance benefit of $49,000 (in addition to the 401(k) benefit) and the annual cost to fund the NHCEs’ benefit would be approximately $5,000. For this example, the actuary developed a benefit formula to produce the desired contributions and benefits within the employer’s contribution and cost parameters. Remember, this is a defined benefit plan. Although the tendency is to focus on the lump sum cash balance, the plan promises to pay a specific pension (a life annuity commencing at normal retirement age, 65 in this example). In this example, the contribution level, together with plan earnings, was designed so that the cash balance “accounts” would equal the plan’s funding target each year. This minimizes the risk of underfunding and financial statement impact. In other words, the goal for this example is to have the value of the cash balance accounts equal the present value of the plan’s liability each year.

This sample is an illustration only, demonstrating the benefits of cash balance design on limited facts. Your particular employee census and plan objectives must be independently considered to determine the plan design and features that are best suited to your circumstances.

How can the plan have 2 different benefit levels? Cash balance plans may satisfy a nondiscrimination safe harbor by providing uniform pay credits for all employee participants. However, the cost of this safe harbor results in few small employer plans utilizing this design. Instead, most cash balance plans satisfy a general nondiscrimination test by comparing the HCEbenefit rates to the NHCE rates to assure compliance. [For another example of general nondiscrimination testing and compliance, but in the defined contribution setting, see Leverage 401(k) Plan with Cross-Testing 7/2002 release date at] Although the 20% vs. 2% may seem extreme in this example, remember that the employer maintains a profit sharing/401(k) plan to which the employer contributes approximately 13% for each participant which is taken into consideration for testing (and passing) the nondiscrimination test.

The employer in this example obtains an additional $49,000 benefit which, at 35% deduction, more than pays the cost of the benefit for the NHCEs, the annual administration costs, and the start up cost of the plan.

What else should be considered?

  • Cash balance plans have had a stigma since litigation in the 1990’s (IBM and others) related to traditional defined benefit plan conversions. However, IRS regulatory guidance, the IRSreinstatement of its determination program for cash balance designs, and definitive cash balance provisions in the Pension Protection Act of 2006 have brought cash balance designs back into favor.
  • Cash balance plans may not impose a last day of employment requirement for accruing a benefit.
  • Cash balance plans require accelerated vesting - 100% vesting must occur over a period not to exceed 3 years.
  • Cash balance plans are individually designed plans and should be submitted to the IRS for a determination letter. The IRS user fee is currently $1,000; the plan, trust and administrative documentation charges and actuarial work in the plan design are approximately $5,000; and for a plan with less than 15 participants annual administration will be approximately $4,000. The start up and ongoing administration fees will depend upon the number of participants.
  • Cash balance plans are defined benefit plans subject to PBGC premiums ($34/participant per year in 2009 plus $9 for every $1,000 underfunded benefit liability) unless an exemption is available. A substantial owner plan (plan maintained exclusively for sole proprietor, partner who owns more than 10% of capital or profits, or shareholder who owns more than 10% of voting power) is exempt. A small professional service employer plan (never more than 25 active participants and engaged in medical, legal, accounting, actuarial, social or physical sciences, engineering, architectural, drafting professionals or performing arts) is exempt.

[Special thanks to Keith Nichols, E.A., M.A.A.A at Hallett Associates, Inc. for the actuarial work in the “show me” example.]

For additional information, please contact:

David M. Mosier, Esq. Knox, McLaughlin, Gornall & Sennett,P.C. 120 West Tenth Street Erie, Pennsylvania 16501-1461 Telephone (814) 459-2800; Fax (814) 453-4530

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