Cash Balance Plans: A Closer Look
You've done your preliminary research on cash balance plans and think they are right for your organization, but you still have questions. We're here to help you get a more in-depth look at this "hybrid" plan type so you are able to make an informed decision.
What is a Defined Benefit Plan?
Let's start at the beginning. A defined benefit plan is a plan that provides a benefit that is determined by the terms of the plan document. The contribution is actuarially determined as the amount necessary to fund the promised benefit. The law does not limit the contribution; rather, it limits the ultimate benefit that can be paid from the plan. The maximum benefit is a life annuity of $210,000 a year, payable at age 62. It is decreased for commencement ages lower than 62, and increased for commencement ages later than 65. It is also reduced if the participant doesn’t have 10 years of participation at the time of commencement.
Example: DB plan provides a benefit of $15,500 a month life at age 62.
Dr. A is 50 years old. Assuming a 5.5% rate of return on investments, the annual contribution to fund his benefit is $123,000 per year.
Dr. B is 40 years old. Assuming a 5.5% rate of return on investments, the annual contribution to fund his benefit is $49,500 per year.
Disadvantages of Traditional Defined Benefit Plans:
- Final average pay plans weigh benefits heavily in favor of final years of work
- Employees do not relate to the benefits being provided
- Weighted by age as well as salary – older employees cost more than younger employees who earn the same amount
- In the context of small and professional employers, contributions paid do not track directly to benefits paid, requiring eventual adjustments between partners/shareholders when benefits are paid.
Cash Balance Overview
It is a “hybrid” plan in that it is fundamentally a Defined Benefit (DB) plan, but it expresses benefits in the form of a guaranteed account, rather than a guaranteed benefit at retirement. It has the following features:
- The maximum benefit that can be paid follows the normal rules for Defined Benefit Plans.
- The plan provides for a fixed annual credit, and a fixed annual interest credit on the account. For example, a plan might say that the annual credit for Shareholders is $100,000, and the annual interest credit is 5%.
- Participants receive easily understandable statements showing the value of their account.
- The actual required contribution differs from the fixed credit because of differences in the actual investment rates and the fixed crediting rates.
Who Bears the Investment Risk?
In a Defined Benefit plan, because the benefit is guaranteed, the investment risk lies with the employer. The amount of the participant’s benefit cannot vary based on the performance of the plan assets. If the trust performs better than assumed, the required contribution decreases. If it performs worse than assumed, the required contribution increases over time. There cannot be any participant investment choice – all assets are pooled and trustee-directed.
Can the Plan allow for Different Contributions to the Shareholders?
You must be very careful to design and operate the plan in a way that follows all the rules for Defined Benefit plans. Allowing each shareholder to "choose" a different credit amount will fall afoul of the requirements.
However, you know you need to create a schedule of credits that all shareholders can live with. Some examples of safe approaches to consider:
- An equal credit for everyone
- A percentage of salary
- An amount from a table based on age
- A shareholder can be named out of the document and the plan can be amended at a later time to allow the person in at the specified credit.
- The plan can only be amended prospectively and infrequently!
- Once someone has worked 1000 hours they have earned a credit for that year and the contribution must be made. So if you leave during a year and you have worked 1000 hours there will be a required contribution on your behalf!
How Long Should the Plan be Maintained?
The IRS has a permanency requirement and, although there is not an active standard, five years appears to be a sufficient time to satisfy that requirement. Within these five years the cash balance credits can be amended to minimize a contribution, but such an amendment must be done early in the year before benefits are accrued.
In the event of a significant business event (e.g., sale of the business, severe financial downturn, loss of primary contract, etc.), the plan could be terminated. At the time the plan is terminated, a favorable determination letter should be sought from the IRS to ensure that the permanency requirement is satisfied.
What Happens When a Participant Terminates Employment or Retires?
Upon termination of employment, an eligible participant has the option to receive a lump sum distribution or an immediate annuity. The annuity is the default option and, if chosen, the plan would purchase an annuity for the benefit of the plan participant.
If a lump sum distribution is chosen, the participant's spouse (if any) must consent to the distribution. The lump sum can than be directly rolled over into an IRA. In some circumstances, due to IRS restrictions, an HCE may not be able to receive his or her lump sum immediately if the assets would not exceed 110% of the liability after the distribution. This generally happens if the value of plan assets is down due to a decline in the market. In this case the HCE would have three options:
- Leave the money in the plan, where the cash balance account balance will continue to be credited with interest at the 30-year Treasury rate
- Start taking a monthly benefit from the plan
- Roll the lump-sum distribution to an IRA with the requirement that the IRA trustee sign a collateral agreement agreeing to repay monies to the plan, if the plan should terminate with insufficient assets.
For more information on retirement plan design, visit our Knowledge Center.