Welcome back to Part 2 (of 3) of our series on 10 Things Every Cash Balance Plan Sponsor Should Know. Cash Balance Plans are one of the most advantageous yet overlooked retirement plans available. The four main reasons for this are (1) costs associated with establishing and maintaining these plans, (2) wrong demographics for this plan design, (3) the “commitment” required to keep the plan in place, and (4) their complexity
In Part 2 of our 3-part series, I discuss four more things that every plan sponsor should know about Cash Balance Plans.
3. Know the Full Cost of a Cash Balance Plan, And Keep It In Perspective
In my experience working with Plan Sponsors, one of the biggest areas of confusion is understanding the various costs involved with implementing and maintaining the Cash Balance Plan year after year. There are layers of costs, both direct and indirect, associated with a Cash Balance Plan, and an experienced Advisor in this area can add tremendous value when helping you understand and navigate through them, so there are no unexpected or unpleasant surprises later on. It is too difficult to set forth all the costs here to be considered in setting up and operating a Cash Balance Plan; however, some of the more noteworthy costs include:
- Ongoing Plan Administration. Cash Balance Plans are complex and involve having an Enrolled Actuary participate in the administration process including signing the Schedule SB, the Actuarial Certification that must accompany the annual Form 5500, and the information/tax return that all qualified retirement plans are required to file each year. There may also be the cost of paying annual premiums to the Pension Benefit Guaranty Corporation (PBGC) if the Plan is covered by PBGC. As such, the cost to administer these plans can be two to three times the cost of 401(k) plan administration. This one area has potential multiple layers of fees that should be reviewed and understood including set-up costs, ongoing plan administration, separate testing costs, and participant distribution processing, just to name a few. It is important to always keep these costs in perspective, however. While the costs to administer and operate a Cash Balance Plan are higher than that of a 401(k) typically, the potential benefits are significantly greater.
- Required Employee Contributions to Pass Required Testing. There are two key tests that need to be passed in order to keep a Cash Balance Plan in compliance with the IRS. First, Plan Sponsors will need to contribute generally between 5% - 7.5% of eligible participants’ compensation into the 401(k) Profit Sharing Plan to pass required IRS nondiscrimination and coverage testing, depending upon the amounts the Owners seek to have contributed on their behalf. It should be noted that a number of businesses already contribute at least 5% of pay to employees in order to allow Owners to maximize their Profit Sharing plan contributions. These contributions can be used towards meeting this requirement. Second, a “meaningful benefit” must be contributed to a more limited group of people in the Cash Balance Plan to pass minimum participation testing. Firms like ours can show you in detail what these costs would be, and you should have a plan design study or illustration conducted prior to setting up a plan. There are a number of variables here that can impact these costs.
Potential Asset Shortfall Costs. The dynamics of a plan’s asset shortfall is one of the least understood areas by Plan Sponsors, and it can be potentially the greatest cost. Simply stated, this cost is driven by the Interest Credit Rate (“ICR”) and the investment performance around that ICR. These costs can be mitigated not only through proper plan design and utilizing newer, more efficient Interest Crediting Rate (“ICR”) structures, but also by working with an experienced Cash Balance Advisor. However, not every plan administration firm hanging a Cash Balance shingle has the capability to deliver the full complement of ICR choices for Plan Sponsors to consider. Moreover, many Advisers do not fully understand the Cash Balance Investment protocol and can unwittingly subject their Cash Balance clients to higher levels of risk during market volatility. It can be a challenging combination for a Plan Sponsor. The flip side of the shortfall, known as the surplus, can create contribution issues and tax-related challenges for the business and Owners as well. “Shooting the Moon” should be left to the 401(k) or personal assets, not the Cash Balance plan. Make sure you are working with a very experienced team that understands the importance of adopting the right ICR for the plan and further understands the unique investment protocol of Cash Balance Plans. The management of these assets is very different from managing the assets of your 401(k) or private wealth assets.
Other Plan Costs. There are other potential cost factors to consider in establishing and maintaining the Cash Balance Plan. These will vary depending upon the number of eligible plan participants, whether or not the Plan is covered by the Pension Benefit Guaranty Corporation, overall firm demographics, plan objectives, and the expertise of the team you put together to help you manage this multimillion-dollar tax deduction. It bears repeating that while the costs to implement and operate a Cash Balance Plan can be higher than that of a 401(k) Profit Sharing Plan, the potential benefits to Owners can be significantly higher to the Owners of the business.
4. Know the Guarantee of the Cash Balance Benefit
At the heart of every Cash Balance Plan is a promise by the Plan Sponsor guaranteeing participants not only the contributions made by the Employer on behalf of the participant but also the earnings based on the Plan ICR). Simply put, the plan assets must earn a rate of return consistent with the plan’s ICR as stated in the plan document
The goal is for the underlying investment performance on the plan assets to keep pace with the Plan ICR. If that doesn’t happen, and the ICR doesn’t keep up on an annual basis at the plan level (for Plans using a fixed or indexed ICR), or on a cumulative basis at the participant level (for Plans using a Market Actual Rate of Return ICRs), the plan would be considered to have a shortfall and potentially move into an underfunded status.
If a plan moves into underfunded status, there are a number of remedies for the Plan Sponsor to pursue including, but not limited to:
- Do nothing and let the investments recover. This is a simple, straightforward approach but has other consequences such as departing Owners leaving their share of the shortfall behind for the remaining Owners to absorb, without certain protections in place.
- Amortize the shortfall over a 15-year period. A $150,000 shortfall, for example, could allow for the Plan Sponsor to contribute an additional $10,000 per year for 15 years or pay it off sooner if they so desired. This approach has the same consequences as discussed above, among others.
- True-up the shortfall in one payment. A true-up allows the Plan Sponsor to make up the difference within one plan/tax year. In doing so, most of that true-up contribution will go into the Owner’s accounts effectively allowing them to receive a greater deduction or contribution for the shortfall year in question. In effect, the Owners are paying themselves that difference, and the government is subsidizing it via an immediate tax deduction to defer taxes. This is not something available to Owners in a 401(k) Profit Sharing Plan who are limited each year to the fixed maximum amount as published by the IRS each year (see above for the maximum limit for 2023).
- Amend the plan to reduce future contribution credits/benefits paid to the plan participants, assuming the plan is not covered by PBGC. This is obviously less than ideal and could cause some headaches to all parties involved.
Each of these options has pros and cons with their respective approaches. However, the main point to remember is the considerable flexibility allowed from year-to-year, particularly if you work with a team that understands each of the options and their respective consequences in order to make a fully informed decision.
5. Know That Cash Balance Plans Have the Element of “Permanence” in the Eyes of the IRS
Whenever I have been involved in setting up a Cash Balance Plan for a Client, the question inevitably turns to how long the plan needs to remain in place. While there is no formal IRS rule or regulation specifically on point answering this question, it is clear from the IRS’s point of view that they intend the plan to have an element of “permanence” about it. This has been interpreted to mean that plans should be established with the intent of operating it for years into the future.
However, as with most things, there is both a technical and practical answer to this question. The “safe-harbor” technical answer is 5 to 10 years, with 10+ years being the preferred number of years by the IRS. The practical answer is that life happens. Partnerships dissolve, Companies are acquired or merged, Owners grow tired or the business cannot, or no longer want to support the financial commitment needed to fund the larger amounts to a Cash Plan, the Plan meets its objective, and so on. A best practice approach generally holds that the plan should be operational for at least 3-5 years unless there is a “material change to the business.” What constitutes material change? That will be dependent upon the specific facts and circumstances of each situation. Losing a major client, dealing with a significant economic event that affects your business or industry, or the retirement or death of key Owners are all examples that may qualify as a material change.
Perhaps the more practical side of this question relates to the associated costs involved with both setting up and terminating a Cash Balance Plan. These plans can be expensive to set up and even more expensive to terminate. We didn’t list the cost of terminating the Cash Balance Plan above in reviewing plan costs, but you should know what that cost is and factor it into your overall costs. If you seek to operate the plan for only a three-year period between those bookends, it may not be worth the benefit, unless Owners plan to have a considerable amount contributed on their behalf during that period. This is yet another area that an experienced team can help you explore.
6. Know That Contributions Should Be “Definitely Determinable” for a Period of Time
Cash Balance Plans are widely recognized as a way to generate large contributions/tax deductions for Owners while deferring taxes and accelerating their retirement savings in the process. To capture those two benefits, however, Owners need to make a commitment to those contributions for a set period of time before changing it. When a plan is established, the participant's name and contribution amount are literally written into the plan document. As discussed above, that contribution needs to be both “definitely determinable” (a fixed amount or percentage of pay) and needs to have an element of permanence attached to it, meaning it needs to remain in place for a period of time. That period is the subject of much debate within actuarial circles; however, generally speaking, a 3-5 year time frame is the minimum period unless there is a material change in circumstances with your business.
Each time a contribution change is made, it requires a Plan Amendment, and if benefits are reduced a 15-day (45 days for larger plans) advance notice to participants. Too many or too frequent contribution changes can send up red flags to the IRS that your plan is nothing more than a super-sized 401(k) plan, which as mentioned above has its own legal annual contribution limits. Establish a firm policy regarding contribution changes (e.g. survey owners every 3-5 years to make changes. It is best if such changes are few and far between to avoid undue scrutiny from the IRS.
Do You Want Helping Maximizing Your Cash Balance Plan?
While we try our hardest to clearly explain all the rules and benefits of a Cash Balance Plan, there is simply too much to explain in one (or even three) blog posts. If you would like help in understanding the benefits a Cash Balance Plan can offer, while staying in compliance with all the rules and regulations, we would love to help.
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 last 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.