IRS proposed cash balance plan regulations allow equity-based rates of return

On October 18, 2010, IRS released final and proposed regulations with respect to hybrid plans, including cash balance plans. The rules under both the final regulation and the proposal are very technical and deal in detail with a variety of issues applicable in limited situations (e.g., the treatment of variable annuities).

We assume that, generally, sponsors have for some time been in compliance with post-PPA rules with respect to cash balance plans. We are not going to review either the final regulation or the 2010 proposal in detail. Instead, this article will focus on issues related to a significant new provision in the proposed regulation allowing for the use of equity-based crediting rates.


We assume a general familiarity with cash balance basic operations and terminology. We do, however, want to explicitly review some cash balance plan terminology that may be confusing. In this article we’ll be speaking about cash balance plans, understood generally as defined benefit plans that describe a participant’s benefit in terms of the value of a hypothetical account to which pay credits (hypothetical “contributions”) and interest credits (hypothetical “earnings”) are made. While “interest credits” is a generally accepted cash balance term, as we use it at least, interest credits don’t have to, literally, involve “interest.” Interest credits could, for instance, be based on gains and losses on a hypothetical (or actual) equity portfolio. And in some circumstances those equity-based interest credits could be negative; that is, they could reduce the value of the participant’s account.

Prior to passage, in 2006, of the Pension Protection Act (PPA), cash balance plan sponsors, to avoid regulatory problems (principally “whipsaw”), generally used a safe harbor interest crediting rate — based on a bond or Treasury instrument index — to determine interest credits in a cash balance plan. The PPA authorizes the use of any interest crediting rate that is not in excess of a “market rate of return” — clearly contemplating the possibility that a plan might base interest credits on an equity index. The PPA also added a “preservation of capital requirement,” generally requiring that the participant’s benefit be no less than the sum of all pay credits, thus putting a “floor” on losses that could be “credited” to an account.

In 2007 IRS proposed regulations that, while refining the list of fixed income crediting rates, reserved on the issue of what sorts of equity-based crediting rates may be used without violating either the market rate of return or preservation of capital rules. The 2010 proposed regulations address this issue, providing a specific set of rules for what sorts of equity-based returns may be used. They also provide rules with respect to permitted return “floors,” minimums and fixed rates of returns that may be used.

Equity-based rates of return

Generally, under the 2010 proposal, a plan may, in addition to previously identified fixed income crediting rates, use as the interest crediting rate:

Return on plan assets. The actual rate of return on plan assets, provided that the plan’s assets are diversified so as to minimize the volatility of returns. (The requirement that plan assets be diversified so as to minimize volatility of returns does not require greater diversification than is required under ERISA section 404(a)(1)(C).)

Return on an investment company. The rate of return on a regulated investment company that is reasonably expected to be not significantly more volatile than the broad United States equities market or a similarly broad international equities market. Examples of regulated investment companies that qualify: those that track the rate of return on the S&P 500, a broad-based “small-cap” index (such as the Russell 2000 index), or a broad-based international equities index.

So, under the proposal, cash balance plans may now use an equity-based rate of return, so long as it is not too volatile.

“Floors,” minimums and fixed rates

One of the issues left hanging in the 2007 proposal was how an equity based rate of return could comply with both the market rate and capital preservation rules. The obvious reason for limiting equity-based rates of return to funds that minimize volatility was to avoid use of a highly volatile index with a guaranteed floor — a combination that would likely exceed a market rate of return.

The 2010 proposal also includes new rules as to what sorts of “floors” on returns, minimum returns and fixed returns may be used. Generally:

With respect to safe harbor fixed income rates of return, the plan may provide for an annual floor rate of 4 percent.

With respect to equity-based rates of return, the plan may provide for a cumulative floor of 3 percent.

A plan may provide for a fixed rate of return of 5 percent.

We note that the general rule is that returns may not be in excess of a market rate of return. Thus, under the final regulation, plans may provide for an interest crediting rate that is a percentage (less than 100 percent, e.g., 90 percent) of a safe harbor interest crediting rate.

When does the new rule apply?

While the 2010 proposal, if finalized, would apply to plan years that begin on or after January 1, 2012, a plan is permitted to rely on the 2010 proposal for periods before the regulatory effective date. So, in effect, a sponsor could implement an equity-based rate of return (or a minimum or floor, etc.) immediately. Obviously, roll-out of such a program will take some preparation, but as a general matter sponsors may begin the process of implementing it immediately.

Transitioning to an equity-based rate

We assume that most sponsors of cash balance plans are currently providing interest credits at a safe harbor rate. Generally (and for somewhat technical reasons), for plans that are already using a safe harbor rate, changing to a different rate — e.g., an equity-based rate — is not simple. The ability to accrue interest credits at the old rate must be preserved for pay credits in participants’ accounts prior to the change to equity-based rates.

If you want to move all old money to a new equity-based rate, you can “wearaway” the old benefit. Generally, this would involve running (1) an old account with principal credits to the date of amendment + “old” interest credits thereafter and (2) a new account with all principal credits + “old” interest credits to the date of amendment + equity-based interest credits thereafter, and providing the participant the greater of (1) and (2). At some point (2) will (practically) be greater than (1). This approach is obviously complicated and will, at a minimum, present a communications challenge.

Alternatively, a simpler approach would be to continue to provide old interest credits on old money and new equity-based credits on new money.

Like a 401(k) plan?

Much of the demand for equity-based credits in cash balance plans derives from a sponsor (and participant) preference for 401(k)-style investing in those plans. And we assume that, generally, sponsors who implement equity-based credits will want to give participants a choice between equity-based credits and a fixed income credit. Sponsors will want to consider the administrative complexity — running, in effect, multiple accounts for different time periods each using different crediting rates — of allowing participant choice. Given the complexity of moving from one approach to the other, it is unlikely that sponsors will want to allow, e.g., daily or weekly or even monthly changes.


The final and proposed regulations include comprehensive rules with respect to the design and operation of cash balance plans. As a general matter, most sponsors’ plans will be in compliance with most of these rules. The deadline for amendments to bring plans into compliance is, for non-collectively bargained plans, generally the last day of the first plan year that begins on or after January 1, 2010.

We have focused on the issues related to the adoption and implementation of equity-based rate of return provisions. Sponsors of cash balance plans will want to consult with their legal and tax advisers and their actuary concerning this issue and concerning general compliance with the new rules.