For nearly 20 years I’ve had a front-row seat to Cash Balance Plans from both the plan administration and Investment Advisor side. I’ve seen how compelling these plans can be in generating sizable tax deductions and accelerating the Owner’s retirement savings. They allow business owners to squeeze 20 years of retirement savings into 10 while dramatically lowering their tax liability. They also benefit staff since various IRS tests require additional contributions be made to non-Owner participants in order for the business Owner(s) to receive the benefit(s) that Cash Balance Plans can generate. So, they can be a win-win plan design.
The problem is, these are complex plans with many moving parts that can prove to be challenging to the business if not properly managed or understood. These plans have historically been implemented late in the year as the decision-makers rush to meet year-end or tax filing deadlines. As a result, key plan design issues that can impact the business are frequently minimized, glossed over, or left out of the discussion completely in the pursuit of the large contributions/tax deductions inherent in these plans.
With that in mind, I have written a top ten list of the things Plan Sponsors should consider before adopting a Cash Balance Plan. Some of these items warrant their own dedicated article but I am hopeful that a brief review of these topics will spur Plan Sponsors to explore them in greater detail with those that specialize in this corner of the retirement plan world. As to this last point, given the complexity and business implications inherent in these plans, and further given the high stakes involved for the Owner(s), it is critical for decision makers to work with an experienced Advisor/Actuarial team that specializes in these plans to ensure the relevant issues are explored in depth without any limitations.
Here are the first two items on the list:
1. Understand What a Cash Balance Plan Is and Is Not
Qualified Retirement Plans are categorized as either Defined Contribution or Defined Benefit Plans. Defined Contribution Plans define the legal limit that one can contribute toward their retirement and typically allow the participant to manage and invest their contributions among a menu of investment options, which ultimately determines the benefit outcome. For 2023, participants in 401(k) plans can contribute $22,500 ($30,000 for those age 50+),and can have additional Profit Sharing contributions up to the legal limit of $43,500, for a total of $66,000 ($73,500 for those age 50+) per year. These contribution limits require the plan to pass discrimination and coverage tests, among others.
A Defined Benefit plan provides a more certain retirement outcome by defining the benefit that a participant will receive based on a formula that includes age and years of service. The funding for it comes from the Employer. A Cash Balance Plan is a defined benefit plan but is often referred to as a “hybrid plan” since, instead of a monthly pension benefit, the Cash Balance participant has an account balance that makes it look and feel like a 401(k) plan. The account balance consists of contributions made on behalf of the participant (referred to as a “pay credit”), along with earnings (referred to as an “interest credit”) tied to an IRS approved Interest Credit Rate (“ICR”). The aggregate combination of these two annual additions creates the participant’s “hypothetical” account balance, which is the promise by the business to pay to the participant when the participant separates from service. The maximum benefit that a participant can receive in a Cash Balance Plan is $265,000 per year for life at normal retirement age (adjusted for inflation). From an actuarial point of view, this is the equivalent of approximately $3.4 million in a lump sum. Annual contributions can range from approximately $70,000 to $400,000, above and beyond the 401(k) Profit Sharing Plan contribution limits for the year. In a world of declining tax deductions, this plan design can offer dramatic tax savings.
While those numbers are compelling, it is critical for Plan Sponsors and their Owner participants to remember these Plans are NOT 401(k) Profit Sharing Plans. Unlike the discretionary contribution nature of a 401(k) Profit Sharing plan, which allows you to change the amount being contributed at a moment’s notice, Cash Balance contributions must be made through a ‘definitely determinable” arrangement and must remain fixed for a certain period of time. While neither the Internal Revenue Code or IRS Regulations speak to what that length of time is, the industry has settled on a best practice approach of between 3-5 years. Sponsors need to stick to the definitely determinable formula and the best practice contribution time frame to stay out of the IRS’s crosshairs.
Another big issue for Plan Sponsors to fully understand is the selection of the underlying Interest Credit Rate (“ICR”), embedded into every Cash Balance Plan. The ICR impacts nearly every aspect of the Cash Balance Plan and is the main focus of the investment strategy. Unfortunately, all too often Plan Sponsors merely adopt the ICR that they are told to use without exploring all available options. The universe of options presented may be limited by the capabilities and/or knowledge of those providing the options. Worse, rarely do those setting the ICR coordinate with those responsible for consistently generating returns to hit that ICR, in all seasons, net of expenses. The net effect of this failure to coordinate can lead to exposing the plan assets to greater market risk if the financial markets become volatile. Plan Sponsors should make sure they fully review all options with those that both understand them and can deliver them, before making a final decision on the ICR.
Historically, traditional ICRs have been classified as either (1) a floating rate, such as the yield on the 30-year Treasury Bond recalibrated the first day of each plan year, or (2) a fixed interest rate such as 2%-6%. For those plans using traditional ICRs, the goal of the investment strategy is to generate an investment return which consistently “hugs” that ICR each year, net of all fees, during all market cycles, which can be challenging. If you exceed the targeted ICR you enjoy a surplus. If the returns are below the ICR for the year, you encounter a shortfall. While both surpluses and shortfalls have potential consequences for the Plan Sponsor, the shortfall poses the bigger challenge. A 5% investment loss for the year, for example, will generate a 10% shortfall on the hypothetical account balances for the year. For a $1 million Cash Balance Plan, that translates to a $100,000 shortfall. As plan assets increase over time, negative investment returns can place increasing pressure on the cash flow of the business.
Plan Sponsors can manage these shortfalls either by (a) doing nothing and hoping the financial markets move higher allowing for some or all of that shortfall to ultimately be recovered, (b) amortize that shortfall over time, with seven years being the maximum or (c) make a true-up contribution to eliminate the shortfall. There are advantages and disadvantages to each of these options, depending upon the size of the shortfall.
There is a third ICR option called the Market Rate of Return (MRR), once reserved for larger plans, making its way into the smaller plan market. In effect, MRR allows the Plan to use the investment performance of the plan assets for the year in question as the ICR for that year rather than fixing on a specific target. MRR is increasing in popularity because of what it offers the Plan Sponsor – relief from the pain of annual true up contributions at the plan level in down market years. Plan Sponsors only need to address a “shortfall” at the participant level (a) when a participant separates from service and (b) only if that participant’s cumulative account balance is less than the contributions that were made on his or her behalf over their time in the plan. This is a much better structure than the traditional ICRs that focus yearly on shortfalls at the plan level. Participant account balances move in harmony with plan assets, keeping the plan fully funded at nearly all times. MRR limits the business risk to those participant’s leaving, with an account balance less than the cumulative contributions made to their accounts.
Sponsors should understand that while MRR is becoming the ICR of preference for new Cash Balance Plans, existing Cash Balance Plans can take advantage of what MRR has to offer through a plan amendment which may help you better manage your current shortfall situation.
Properly constructed and managed, Cash Balance Plans can “squeeze 20 years of savings into 10 years” for high-wage-earning Owners, providing substantial tax deductions along the way. In a world of shrinking tax deductions for high-wage earners, the Cash Balance Plan design provides a compelling solution. Given the complexity and business implications inherent in the design and operation of a Cash Balance plan however, it is critical for decision makers to work with an experienced Advisor/Actuarial team that specializes in these plans to ensure the ICR issue is fully vetted and other relevant issues are explored in depth without any limitations.
2. Separate and Distinct, But Still Covered by ERISA
Cash Balance Plans are separate and distinct plans with their own 5500 filing requirement. It is important to understand these plans are “qualified” plans, just like the 401(k) Profit-Sharing Plans. They are covered under ERISA and have their separate IRS requirements to stay in compliance, including, but not limited to, the four main tests at the heart of every qualified retirement plan: contribution/deduction limits, coverage testing, minimum participation testing, and discrimination testing. In order to take advantage of more generous testing allocations under the tax code, Cash Balance Plans are typically paired with an existing 401(k) Profit-Sharing arrangement and are tested together. Under this structure, Cash Balance Plans get to take advantage of a more liberal discrimination testing allowance for Profit-Sharing Plans and can satisfy their own discrimination testing requirements by leveraging the Profit-Sharing contributions.
All too often I notice that Plan Sponsors and their Advisors fail to consider Cash Balance Plans to be covered by ERISA since these plans do not have the fanfare of 401(k) plans. The cold hard reality is that they ARE indeed covered by ERISA. Plan Sponsors should have a governance process that includes Investment Policy Statements, Committee Charters, ongoing Committee Meetings Minutes of those meetings, etc. They are also subject to an outside independent audit if the number of eligible participants and terminated with account balances exceeds 100. If your team is not leading you through this fiduciary governance process, that should be a tell as to their knowledge and understanding of these plans.
Need Help Navigating Your Cash Balance Plan?
If you have a Cash Balance Plan, or are interested in setting one up, don’t try to do it all on your own. At SageView Advisory Group, we have years of experience helping clients navigate decisions about their retirement plans. Our firm offers an in-depth review of your Company or Firm to determine the best retirement plan. Send a census of your Company or Firm to ssansone@sageviewadvisory.com, and I’ll have that analysis completed and back to you in 72 hours.
And stay tuned for our next article, in which we'll cover the next four points of what every Cash Balance Plan Sponsor should know.
About Steve
Steve Sansone has over 30 years of experience in the retirement plan industry and is the Managing Director of the Valencia office at SageView Advisory Group, one of the largest Registered Investment Advisor firms specializing in retirement plans. As an Accredited Investment Fiduciary® and Certified Plan Fiduciary Advisor practitioner, Steve works with professional service groups and companies of all sizes seeking to create a world-class retirement plan experience for their plan participants. He serves as an ERISA 3(21) or 3(38) Advisor, bringing independent, conflict-free services to both Plan Sponsor Committees and retirement plan participants. Steve’s expertise in Cash Balance Plans spans nearly 20 years and is one of the few Advisors in the industry that understands both sides of the Cash Balance equation: Actuarial and Investments. He considers his work to be the greatest financial rescue mission of this time, helping people retire on time, sufficiently prepared to write the next best chapter of their life. To learn more about Steve, connect with him on LinkedIn.
SageView Advisory Group, LLC is a Registered Investment Adviser. Advisory services are only offered to clients or prospective clients where SageView Advisory Group, LLC and its representatives are properly licensed or exempt from licensure. No advice may be rendered by SageView Advisory Group, LLC unless a client service agreement is in place.