Fixing Fixed-Rate Cash Balance Plans

“Why are we being told we have to contribute much higher amounts to our cash balance plans than ever before?”

ERISA consultants at the Retirement Learning Center (RLC) Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs, qualified retirement plans and other types of retirement savings and income plans, including nonqualified plans, stock options, and Social Security and Medicare.  We bring Case of the Week to you to highlight the most relevant topics affecting your business.

Recently, we have received calls from advisors with a repeating concern related to cash balance plans.

Highlights of the Discussion

This is a common concern among certain cash balance plans, and often comes with no warning or creative fixes from their current consultants. Our response is to ask about the plan’s rate of return in 2022 and explain why that is relevant to their required contributions. We start here because most cash balance plan sponsors have what we call a “fixed-rate” plan design, which is a design that promises a positive return (sometimes as high as 5%) every single year. When assets post double-digit investment losses, like many did in 2022, this design will result in unwelcome news of much higher required cash outlay to keep their plans funded.

We then explain there is a better approach to consider that can keep contributions (and deductions) more predictable.  Enter the “market return cash balance” (MRCB) plan. Instead of designing a cash balance plan with a fixed interest rate, MRCB plans are designed to credit accounts with the actual investment return in the plan’s trust. This can make a huge difference in funding stability as illustrated next.

In the following example, a sponsor has committed to a $100,000 annual contribution, and the plan has a design promising a 4% fixed interest rate of return.  See the investment returns from 2016 to 2022 below, under Actual Return.

The fix-rate design created a mismatch between the promised benefits and the assets backing them. To keep the plan funded, the contribution had to fluctuate year-to-year, as shown in the column second from the right.

As a fixed-rate plan matures, one bad investment return year can have drastic consequences to the required funding levels. This often comes at an inopportune time. In this case, the -15% return in 2022 turned a $100,000 contribution into $226,000.

By contrast, look at the column on the far right. MRCBs, when designed correctly, can mitigate this problem and result in a smooth experience for plan sponsors.

Making the Switch

Advisors have asked us, how hard is it to switch from a fixed-rate design to MRCB design? It’s much simpler than one might expect. Plans often can either be amended or restated without the need to terminate the program. This affords sponsors minimal disruption.

While sponsors cannot reverse the 2022 underfunding problem they may be facing, they can move to an MRCB design prospectively. There are ways to smooth out the “make-up” contributions over time while the plan recovers.

Conclusion

Most plan sponsors of fixed-rate cash balance plans are facing a challenging funding result after negative 2022 returns. In some cases, this news has already been delivered, but others may not realize the problem for several months. Specifically, plans that are valued at the beginning of the year were measured on January 1, 2022, which is before the market loss. This means their 2022 contributions may be funding an outdated result, and this won’t be addressed until after a 2023 valuation is completed. For more information, please see the article, “Advantages to a Market Return Cash Balance Plan Design.”