Conventionally, returns in cash balance plans are credited based on a fixed rate defined in the plan document. However, more attention has been raised recently to the idea of utilizing actual rates of returns in cash balance plans. This is a concept that gains in popularity as the market grows, but may have unexpected consequences on the complicated “behind the scenes” compliance testing to ensure a plan remains qualified.
On the surface, utilizing actual market rates of return seems to be the best option to allow each participant in the plan to share equitably in investment gains and losses of the plan assets. However, in the small company context, these plans are subject to very complex testing methodologies to ensure the plan is nondiscriminatory, provides meaningful benefits to the appropriate number of eligible employees, and is not providing benefits in excess of the maximum allowable benefit. Failure to satisfy any of these requirements (not an all-inclusive list) may result in plan disqualification and loss of past and/or future favorable tax treatment.
In the smaller company/small plan arena, larger benefits are typically provided to the Highly Compensated Employees (HCEs) than to the Non-Highly Compensated Employees (NHCEs) in the cash balance plan. Additionally, the cash balance plan provides the larger portion of the overall benefit of the HCEs. The majority of the NHCEs’ benefits are provided in the defined contribution plan (e.g., employer funded profit sharing contributions). The determination of whether benefits are nondiscriminatory is based on the combined benefits of the two plans.
Although often glazed over or forgotten, a cash balance plan is a defined benefit plan. As such, the accrued benefit is the key element in testing compliance with the above requirements. The accrued benefit is a monthly annuity payment beginning at normal retirement age, e.g. $500 per month starting at age 65 for the life of the participant.
The method for determining the accrued benefit used for testing purposes has not been formally defined in written guidance from the IRS. However, the IRS’ position has been verbally offered during conferences and presentations. So we, as third party administrators, consultants, and actuaries, are left with two options. We can either use the position stated by the IRS or come up with our own method and hope that it will be acceptable if/when final rules are published or if the plan is audited.
Let’s assume we believe the position of the IRS will be the ultimate method provided in written guidance. Without getting into the mathematical calculations used in the determination of the accrued benefit, the use of actual rates of return will have the following impacts: A high rate of return will produce a larger accrued benefit; A low rate of return will produce a smaller accrued benefit.
If the HCEs are receiving larger benefits in the cash balance plan, a high rate of return makes them even higher. However, the NHCEs’ benefits are minimally impacted by the high rate of return in the cash balance plan. Therefore, the overall benefits being provided will less likely be nondiscriminatory. This would require additional contributions to be provided for the NHCEs. In an extremely favorable market environment, this could be prohibitively expensive.
The maximum allowable benefit that can be paid from a cash balance plan is measured as an accrued benefit, which is translated to an equivalent maximum lump sum. This maximum lump sum may or may not be the same as the hypothetical account balance. Because of the methodology that must be used to adjust the maximum allowable benefit payable before age 62, if the rate of return is high in the year a participant is due to be paid out, the maximum allowable accrued benefit will be low and the maximum allowable lump sum will be small. For example, the maximum lump sum could be $1,000,000 if the rate of return is 5%, but would be $110,000 if the rate of return is 20%.
Generally, every defined benefit plan must provide meaningful benefits to a minimum number of participants. If the actual rate of return is low in any given year, the benefit accrued for that year would be small. If too few participants accrue a meaningful benefit, additional benefits would have to be provided in the cash balance plan. This would typically impact the NHCEs and not the HCEs.
All defined benefit plans are subject to benefit restriction rules based on the funded status of the plan. Benefit restrictions could mean lump sum payments are limited or completely restricted, and benefit accruals could be frozen. In general terms, the funded status is measured as the ratio of assets to benefit liabilities. Benefit liabilities are directly impacted by the interest credit rate used in a cash balance plan. A plan using the actual rate of return would have high liabilities in a year where the actual return is high and lower liabilities where the actual return is low. Because benefit liabilities are projected into the future, high investment returns alone may subject the plan to benefit restrictions.
One final point to consider is that a distribution to a participant must be at least equal to the accumulated contributions credited in the cash balance account. In a worst case scenario, the plan sponsor would be required to provide additional funding to make up for a negative investment return.
For the reasons noted above, we would typically recommend against using the actual rate of return as the plan’s interest credit rate. However, there are some limited cases where these issues do not pose significant problems. If you are interested in discussing your specific situation, please contact our office.
— Virginia C. Wentz, EA, FSPA, CPC