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As required by the Pension Protection Act, in 2010 IRS issued regulations that allow a cash balance (CB) plan to base interest credits on ‘market rates of return.’ This new plan design allows the employer to transfer investment risk, and reward, in a cash balance plan to the participant – just like a defined contribution plan.
This new design is a win-win for employers and participants. Employers no longer have to bear investment risk – something that still exists in ‘traditional’ cash balance plans (see 2008) and that may result, in a period of rising interest rates, in significant and unexpected employer losses.
However, some businesses are uncomfortable with this new design, and misconceptions are expected. Here are some of the most common misconceptions and myths about Market-Based Cash Balance plans, and what the reality is.
Myth: Contributions to a market-based cash balance plan must be made on the last day of the year to avoid sponsor investment risk.
Reality: The plan can be designed to provide for contributions on a later date (e.g., by providing that interest credits on new accruals don’t begin until March 1), if the sponsor prefers to make the contribution after the end of the year.
Myth: Widely fluctuating interest-crediting rates will result in the failure of some Tax Code requirements.
Reality: There are a number of issues raised by Market-Based Cash Balance plans that the IRS has yet to rule on. All of those issues can be easily solved by a simple, cumulative floor/cap on returns of, say, 0%-7%, not 4%-6% (as some have suggested).
Myth: High interest-crediting rates in Market-Based Cash Balance plans will increase the probability that the Top 25 highest paid employees will not be able to receive lump sum payments in advance of plan termination.
Reality: The Top 25 lump sum issue exists for most CB plans, not just Market-Based Cash Balance plans. And where it’s a problem, it is easily solved by a modest acceleration of funding.
Myth: High interest-crediting rates will increase required minimum distributions after age 70-1/2.
Reality: If you have a bigger account, you will have to take out more at 70-1/2. But the more assets earn, the bigger the tax benefit, which is the reason for saving in a qualified plan in the first place. Having a big account is a good thing.
Myth: Low interest-crediting rates may mean that there is no opportunity to contribute to make up the investment losses.
Reality: A Market-Based Cash Balance plan works like a defined contribution plan. Properly run, benefits more or less equal plan assets. There is no need to make up investment losses any more than there would be a reason to make money off investment gains. In most cases, investment returns (positive and negative) go to the participant.
Myth: Widely fluctuating interest-crediting rates mean uncertainty as to future income, which is especially an issue for fiduciaries with non-owner employees.
Reality: There is no more fiduciary risk in a Market-Based Cash Balance plan than there would be if you sponsored a DC plan. One of the goals of a Market-Based Cash Balance plan is for the sponsor to stop taking investment risk and for that risk, and the related reward, to go to the participant.
It should be noted that not all Cash Balance plans are created equal. Selecting the right design is crucial for ensuring predictable tax savings and sustainable contributions. There are two types of Cash Balance plans:
Fixed-Rate Cash Balance: Uses a fixed interest crediting rate (e.g., 5% or the 30-year Treasury rate) for steady, consistent growth. However, traditional, fixed-rate and/or bond-yield, Cash Balance plans often provide increased sponsor risk and weak participant returns. The risk they present to the sponsor is completely unhedgeable. In this sense, they are worse than a traditional DB plan, which can be ‘de-risked’ with a bond portfolio.
Market-Based Cash Balance: Ties interest credits to actual investment performance, allowing account balances to grow with market returns. A well-run Market-Based Cash Balance plan works, in essence, like a DC plan – minimizing sponsor investment risk and providing participants the opportunity to reap real, market-based returns. The problem many consulting firms have with cash balance plans is largely administration, which is a problem we can solve for.
Whether you need to reward key executives, reduce tax exposure, or boost retention with long-term wealth-building benefits, October Three can help. Request your free Cash Balance illustration today.