Tag Archive for: cash balance

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Cash Balance Plan Amendment for Market Value Return

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“My client wants to stabilize his company’s employer contributions to its cash balance plan by switching the interest rate used in the allocation from a fixed-rate to a market-rate return. The actuary is telling my client that if a cash balance plan is amended to use a market-rate approach the plan document must be submitted to the IRS for approval to be valid. Must the plan be sent to the IRS for approval if the plan is amended to use a market-rate allocation method?

A recent call with an advisor in New Jersey focused on a plan amendment.

Highlights of the Discussion
In most cases, no, it would not be necessary to submit the amended plan for IRS approval. The market-rate allocation option is available in many IRS pre-approved cash balance plan documents and no additional IRS filing or approval would be necessary when amending to a pre-approved plan with a market-rate option.

An employer that adopts a pre-approved plan may rely on the document provider’s IRS-issued opinion letter for the plan if the employer’s plan is identical to the provider’s pre-approved plan (Revenue Procedure 2017-41). The employer cannot have added any terms to the pre-approved plan or modified or deleted any terms of the plan other than by choosing options permitted under the plan.

Older plan documents may not include a market-rate return provision. Perhaps the actuary is using an older plan document with an outdated design.

Conclusion
When using a pre-approved plan document to amend a cash balance plan to include a market-rate allocation option, the plan sponsor can rely on the original IRS approval letter issued to the document provider. Therefore, no additional IRS filing for approval would be required.

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Fixing Fixed-Rate Cash Balance Plans

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“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.”

 

 

 

 

 

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When might a cash balance plan be a good fit?

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“How can I determine if a cash balance plan might be a good fit for a business owner?”

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.

A recent call with an advisor in New Mexico is representative of a common question related to maximizing retirement plan contributions.

Highlights of Discussion

The question of whether to set up a qualified retirement plan has important tax ramifications. Therefore, business owners would be best served by seeking the guidance of a tax professional when making such a decision.

As a type of defined benefit plan, a cash balance plan requires an adopting employer to fund the plan to provide participants with a promised retirement benefit. Cash balance plans are most popular among smaller, well-established firms that have significant and consistent cash flow (e.g., law firms, medical groups, and professional firms such as CPAs, architects, and consultants). They also work well for older small business owners who are no longer making heavy investments in their businesses, and have significant amounts of pass-through income, resulting in high tax bills.

To determine suitability for a cash balance plan, consider the following questions. The more “yes” responses the greater the possibility a business could benefit from having a cash balance plan.

Question Yes No Why it Matters
1.   Is the business owner over age 50?     The potential to contribute more income to a cash balance plan increases with age.
2.   Does the business owner have less of a need to reinvest in the business?     If the owner has put money into the business in prior years, the business is now, likely, well established, freeing up capital.
3.   Does the owner have significant pass-through income?     This can lead to discussions on how to reduce a large tax bill.
4.   Does the owner want to catch-up on saving more for the future?     Cash balance plans allow for higher contribution and deduction limits than defined contribution plans.
5.   Has the business owner shown interest in setting up a nonqualified deferred compensation plan (NQDC) to save more?     NQDC plans do not reduce taxable income for business owners of pass-through entities.
6.   Has the business owner shied away from a define benefit plan due to complexity and employee coverage issues?     Cash balance plans are less complicated to maintain than traditional defined benefit plans, and design features allow owners to maximize contributions for themselves.

As the table below illustrates, cash balance plans can allow much higher levels of contributions than a profit sharing or 401(k) plan. That equates to higher tax deductions for business owners. For some businesses, having both a defined contribution and cash balance plan may be appealing.

2022 Cash Balance Chart

Conclusion

There are some key characteristics to look for in a business owner when evaluating whether a cash balance plan might be a good fit. For the right candidate, a cash balance plan—or even a combination cash balance and defined contribution plan—can provide significant benefits. Above all, whether or not to set up a qualified retirement plan is an important tax-related question that a business owner should only answer with the help of his or her tax professional.

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Hybrid retirement plans

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“Is ‘hybrid’ just another name for a cash balance defined benefit plan?”

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.

A recent call with a financial advisor from Colorado is representative of a common inquiry related to hybrid plans.

Highlights of the Discussion

Sort of—a cash balance plan is a type of hybrid defined benefit plan; a pension equity plan is another type of hybrid plan. The term hybrid applies to a category of defined benefit plan that uses a lump-sum based formula to determine the guaranteed benefit (rather than a formula based on years of service and compensation as is the case with most traditional defined benefit plans). A participant must refer to plan documentation to determine which type he or she may have.

Functionally, hybrid plans combine elements of traditional defined benefit plans and defined contribution plans. Hybrid plans specify contributions to an account (or balance) like a defined contribution plan, but guarantee final benefits like a defined benefit plan. Such plans grow throughout an employee’s career and allow employees to see that growth through an account balance. There are basically two types of hybrid plans: cash balance and pension equity. The account for each participant in a hybrid plan is theoretical, and is not actually funded by employer contributions. The employer contributes to the plan as a whole (covering all eligible workers in the plan) to ensure that sufficient funds will be available to pay all benefits.

Cash balance plans were the first type of hybrid plan, emerging in the late 1980s.[1] Under a cash balance plan an employee’s hypothetical account balance is determined by reference to theoretical annual allocations based on a certain percentage of the employee’s compensation for the year and hypothetical earnings on the account. In a typical cash balance plan, a participant’s account is credited each year with a pay credit (such as 5 percent of compensation from his or her employer) and an interest credit (either a fixed rate or a variable rate that is linked to an index such as the one-year Treasury bill rate).

Another common type of hybrid plan is a pension equity plan or PEP. While pension equity plans and cash balance plans share methods of accumulating value, a major difference is the earnings used to determine the benefit. Cash balance plans specify a credit each year, based on that year’s earnings, whereas pension equity plans apply credits to final earnings (IRS Notice 2016-67).

While traditional defined benefit plans specify the primary form of distribution as an annuity (with lump sums sometimes given as a optional form of benefit), hybrid plans specify the primary form of distribution as a lump sum, which can be converted to an annuity (see Treasury Regulation 1.411(a)(13)–1). Pursuant to Revenue Procedure 2019-20, the IRS provides a limited expansion of IRS’s determination letter program for individually designed retirement plans to allow reviews of hybrid plans, as well as merged plans.

The Bureau of Labor Statistics has put together the following comparison table showing the similarities and differences between cash balance and pension equity plans.

table

Conclusion

The term hybrid plan refers to a category of defined benefit plans that uses a lump-sum based formula to determine guaranteed retirement benefits. Cash balance and pension equity plans are the two most common types of hybrid plans. The provisions of the governing plan document will specify which type of hybrid plan a participant may have.

[1] Bureau of Labor Statistics

 

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