Market-based cash balance plans:myths and reality

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. Under the new design, participants get market-based returns and exposure to equity performance – something which, given the popularity of 401(k) plans, it’s clear they prefer. And it is likely that those returns will result in a bigger retirement benefit.

We call this design a ReDefined Benefit (ReDB®) plan®. It works a lot like a DC plan, with minimal employer risk and upside potential to participants. But it is much more flexible than a DC plan, allowing employers to solve a lot of problems that DC plans simply can’t address.

Some actuarial firms are uncomfortable with this new design. It appears that they do not understand it and do not understand why it appeals to employers and participants. Some have raised questions about it – even though the Pension Protection Act of 2006 (PPA) explicitly approved it, and the IRS has promulgated a substantial body of guidance. Here’s what some firms are saying, and here’s our response.

Myth 1: Contributions to a ReDB® 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 2: Widely fluctuating interest-crediting rates will result in the failure of some Tax Code requirements.

Reality: There are a number of issues raised by ReDB®s that 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 3: High interest-crediting rates in ReDB® 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 ReDB® plans. And where it’s a problem, it is easily solved by a modest acceleration of funding.

Myth 4: High interest-crediting rates will increase required minimum distributions after age 70-1/2.

Reality: This is actually true. 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 5: Low interest-crediting rates may mean that there is no opportunity to contribute to make up the investment losses.

Reality: This is nonsensical. A ReDB® plan works like a defined contribution plan. Properly run, benefits more or less equal plan assets. There is no need (or conceivable reason) 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 – that is the whole point.

Myth 6: Widely fluctuating interest-crediting rates mean uncertainty as to future income, which is especially an issue for fiduciaries with non-owner employees.

Reality: More nonsense. There is no more fiduciary risk in a ReDB® than there would be if you sponsored a DC plan. The whole point of a ReDB plan is for the sponsor to stop taking investment risk and for that risk (and the related reward) to go to the participant.

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The resistance to ReDB designs among consultants is particularly curious in view of recent trends. Among large professional service firms, for example, there is an unmistakable movement over the past five years toward adopting ReDB® designs. At October Three, we are leading the way, having helped dozens of firms navigate the design, implementation, and ongoing administration of these plans.

It is disappointing to see many professional peers trailing so far behind the state of the art. Even more disappointing, however, is a misplaced focus on compliance scare-mongering rather than on the substantial financial risks posed by traditional CB plans as compared with ReDB® plans.

Traditional (fixed-rate and/or bond-yield) CB plans provide a unique combination of increased sponsor risk and weak participant returns – the worst of both worlds. 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.)

The ‘solution’ to this problem typically is to set participant returns so low that the sponsor is assured of clearing the ‘hurdle.’ The only virtue of that approach is that it is ‘easy to understand’ (and, although this is typically left unsaid, easy for the actuary to administer). But what is really easy to understand is that a participant in one these plans is forced to take a return on his or her account that is well below what others get in a 401(k) plan.

A well-run ReDB® plan works, in essence, like a DC plan – minimizing sponsor investment risk and providing participants the opportunity to reap real, market-based returns. There are over half a million DC plans in the US – proof that participants and sponsors like that solution. The real problem many consulting firms have with ReDB plans is – they simply can’t administer them. We can.