A cash balance plan is a qualified employer-sponsored retirement plan that has become
increasingly common in recent years as an alternative to (or replacement of) the traditional defined benefit pension plan. Though it is technically a form of defined benefit plan, the cash balance plan is often referred to as a “hybrid” of a traditional defined benefit pension plan and a defined contribution plan. This is because cash balance plans combine certain features of both defined benefit and defined contribution plans. Like traditional defined benefit plans, cash balance plans pay a specified benefit amount at retirement. However, like defined contribution plans, participants have individual (albeit hypothetical) accounts, allowing for easy tracking of accrued benefits.

A cash balance plan is a “statutory hybrid plan” that has a “lump-sum-based benefit formula.”

The IRS issued final and proposed regulations in 2010 covering various cash balance plan requirements. The IRS subsequently delayed the effective date of those regulations. On September 19, 2014, the IRS issued new final regulations governing cash balance and other hybrid pension plans. While the new regulations are generally effective for plan years beginning on or after January 1, 2016, portions of the regulations that merely clarify provisions included in the 2010 final regulations are effective for plan years that begin on or after January 1, 2011.

HOW DOES IT WORK?

Hypothetical accounts

Each participant in a cash balance plan has a hypothetical individual account or “cash balance” established for record-keeping purposes. With these hypothetical accounts,participants can easily view their accrued benefit at any time, unlike a traditional defined benefit pension plan. In reality however, you as the employer do not contribute to individual participant accounts. Instead, you contribute to the overall plan, and all of the plan assets are held in one pension trust fund that is used to pay benefits when participants retire or terminate employment.

Comparison of benefit formulas with traditional defined benefit plan

Like all defined benefit plans, a cash balance plan “defines” (specifies) the retirement benefit that will ultimately be paid out. However, the way in which retirement benefits are calculated is not the same as with traditional defined benefit pension plans.

Under a traditional defined benefit pension plan, retirement benefits are based on a formula such as a set dollar amount for each year worked, or a specified percentage of earnings. Often, these traditional pension plans calculate an employee’s retirement benefit by averaging the employee’s earnings during the last few years of employment, taking a specified percentage of the average, and then multiplying it by the employee’s total years of service. This typical end-of-the-career approach with a traditional defined benefit plan can increase an employee’s retirement benefit by emphasizing the usually higher, last years of salary.

By contrast, with cash balance plans, the retirement benefit to be paid is the total accumulation of all contributions over the employee’s working career and earnings “credited” to the employee’s hypothetical account as of retirement age. A cash balance plan does not give as much weight to the last years of salary — it looks at an employee’s entire salary history.

Contributions

With a cash balance plan, you, as the employer, credit each participant’s hypothetical account on a regular basis (e.g., annually or monthly). The amount credited is usually a percentage of the participant’s salary, but it may be a flat dollar amount in some cases. Not surprisingly, these credits are generally referred to as “contribution,” “service,” or “pay” credits.

Generally, the maximum amount of compensation that a cash balance plan can take into account in determining the pay credit for a participant in 2018 is limited to $275,000 (up from $270,000 in 2017).

In addition, each participant’s hypothetical account is increased or decreased each period by applying a rate of interest or a rate of return, specified in the plan, to the participant’s accumulated benefit as of the beginning of that period. This is called the “interest credit.” A cash balance plan’s interest credit can’t exceed a “market rate of return.”

IRS final regulations issued September 19, 2014, contain detailed rules governing the “market rate of return” requirement.

The interest credit can be a fixed rate specified by the plan (up to 6% under the new final regulations), or can be based on an index or mutual fund rate of return (for example, the rate of return on U.S. Treasury bills, or the rate of return of the S&P 500). IRS proposed regulations also allow the interest credit to equal the rate of return the plan actually earns on the investment of its own assets, if certain diversification requirements are satisfied (this option can help an employer avoid overfunding or underfunding the cash balance plan).

Even though the interest credit can be based on an equity index, or on the plan’s actual investment rate of return, which may result in negative earnings for a particular period, the participant’s hypothetical account balance at the time benefit payments begin can never be less than the sum of all of the contribution credits to the participant’s hypothetical account. This is referred to as the “preservation of capital requirement.”

The amount that you, the employer, must contribute to the plan each year is actuarially determined, based in part on “contributions” and “earnings” credited to hypothetical accounts, as well as on the actual investment performance of plan assets.

Actuaries base the amount of plan contribution on several factors, including:

• Retirement benefits promised by the plan
• Age, sex, salary, and retirement age of the participants
• Projected interest to be credited to the participants’ accounts
• Projected future salary increases of the participants
• Projected rates of turnover, disability, and mortality of the participants

Like traditional pension plans, cash balance plans must comply with Internal Revenue Code (IRC) Section 415. Section 415 limits the maximum annual benefit per participant in 2018, payable as an annuity commencing at age 62, to 100% of the participant’s highest average compensation for a three-consecutive-year period or $220,000, whichever is less. A participant’s hypothetical account balance cannot exceed the present value of this maximum annual benefit.

Plan assets and investments

Plan assets are held in a pension trust that you, the employer, set up, contribute to, and use to pay benefits when participants retire or terminate employment. Participants in a cash balance plan have no say over the underlying investments selected.

Since the “earnings” credited to participants’ hypothetical accounts are guaranteed and may be independent of actual investment performance, you, as the employer, bear all investment risk (but you also benefit if investments perform better than expected). The performance of plan investments will determine, in part, the contributions you need to make to fund the plan.

Plan distributions

Like any defined benefit pension plan, a cash balance plan (a) must pay benefits in the form of an annuity, unless the employee (and spouse, if married) elects a different form of benefit, and (b) generally can’t pay benefits until retirement or other termination of employment. Unlike most defined benefit plans, however, cash balance plans typically offer a lump-sum payment as a distribution option.

The Pension Protection Act of 2006 encourages “phased retirement” programs by permitting the distribution of pension benefits to employees who have attained age 62, but haven’t yet separated from service or reached the plan’s normal retirement age. The IRS has also issued proposed regulations that allow phased retirement payments in certain limited circumstances.

Plan distributions — the “whipsaw” effect

Prior to passage of the Pension Protection Act of 2006, when an employee chose to receive a lump-sum payment prior to attaining retirement age, the lump sum could in some cases actually be higher than the participant’s hypothetical account balance. Under IRS rules, the amount a participant was entitled to receive was not the participant’s hypothetical account balance, but rather the present value of the participant’s future benefit (calculated by actuaries) at retirement age. The lump sum was calculated by using the plan’s interest credit rate to project the hypothetical account balance to normal retirement age, converting that benefit to an annuity, and then using a statutorily prescribed interest rate (the discount rate) to determine the present value of the annuity. The problem would arise where the plan’s interest credit rate and the discount rate were not the same.

If the plan’s interest credit rate happened to equal the discount rate, the participant’s lumpsum benefit would be equal to the participant’s hypothetical account balance. However, if the plan’s interest credit rate was greater than the discount rate, the participant’s lumpsum payment would be greater than the participant’s hypothetical account balance. This came to be known as the “whipsaw effect.” While this was good for participants, it was generally contrary to the intent of employers establishing cash balance plans. The practice also raised age discrimination issues, since the lump sum payable to a younger worker would be greater than the lump sum payable to an older worker with an identical hypothetical account balance. In order to avoid the whipsaw effect, employers were effectively forced to adopt the discount rate (instead of a higher market rate) as the plan’s interest credit rate.

The Pension Protection Act of 2006 eliminated the whipsaw problem by allowing cash balance plans to pay a lump-sum benefit that’s equal to the participant’s hypothetical account balance, for distributions made after August 17, 2006.

Portability

A significant feature of cash balance plans for your employees is that, should a participant terminate employment prior to retirement age, his or her vested plan benefits are generally “portable.” This means that the funds can generally be rolled over to another employer’s retirement plan or to an IRA, allowing them to remain in a tax-deferred environment.

Alternatively, in some cases, a terminating employee may elect to leave his or her benefits in the cash balance plan, accruing earnings credits and growing tax deferred, until retirement.

WHAT TYPES OF EMPLOYERS SHOULD CONSIDER A CASH BALANCE PLAN?

Almost any type of employer can adopt a cash balance plan, or convert an existing traditional defined benefit pension plan to a cash balance plan. The following factors have contributed to the creation and recent growth of cash balance plans:

• Today’s employees, especially younger ones, want to see benefits that reward them
  early in their careers, not mainly at the end. Younger employees also like the idea that there will be a longer period of time for their benefits to compound. As compared to traditional defined benefit plans, cash balance plans generally reward younger employees more substantially earlier in their careers and spread out the benefits more evenly during the rest of their careers.
• Women and men who have more career interruptions and shorter periods of
  employment often prefer this type of plan if they receive a higher benefit than with a traditional defined benefit pension plan.
• Employees want more portable benefits since job changes have become the norm,
  rather than the exception.
• Employees and employers prefer retirement plans that are relatively easy to
  understand in terms of the amount of retirement benefits.

If these factors describe many of your employees, you may want to consider adopting (or converting to) a cash balance plan. On the other hand, cash balance plans should be considered very carefully where employers have a large number of older, highly compensated employees who have been with the company for a long time. As discussed later, such employees may perceive more value in a traditional pension plan than in a cash balance plan.

Also, before you decide to establish a cash balance plan or convert an existing defined
benefit pension plan, you also need to consider:

• The age, sex, salary, and retirement age of the participants
• The projected future costs of the plan

A cash balance plan puts certain obligations on the employer. When you establish this type of plan, you are making an ongoing commitment for pension contributions. You, not the employees, are taking on the risk of investment performance. If the plan investments do not perform as expected, it will be your obligation to make up any shortfalls.

TAX BENEFITS OF CASH BALANCE PLANS

Tax considerations for employees

When you contribute to a cash balance plan on behalf of your participating employees, those employer contributions are not currently included in the employees’ taxable income. The employees will not pay income tax on the money contributed to the plan as long as that money remains in the plan. Similarly, because a cash balance plan is a tax-deferred plan, investment earnings on plan funds are not currently included in employees’ taxable income either. These employee tax benefits exist for most qualified retirement plans, and are a key incentive for many employees to participate in such a plan.

Of course, when a participating employee begins to receive distributions from the plan during retirement, he or she will generally be subject to federal (and possibly state) income tax on both plan contributions and related earnings. However, the rate at which a distribution is taxed depends on the employee’s federal income tax bracket for the year, and many employees may be in a lower tax bracket when they begin receiving distributions. If an employee receives a distribution from the plan prior to age 59½, he or she may be subject to a 10% premature distribution penalty tax (unless an exception applies), in addition to ordinary income tax.

One important exception from the 10% penalty tax is for distributions made from qualified plans (like cash balance plans) as a result of an employee’s separation from service during or after the year the employee reaches age 55 (age 50 for qualified public safety employees participating in certain state or federal governmental plans).

Tax deduction for employer

Your employer contributions to the plan are generally tax deductible on your business’s federal income tax return for the year in which those contributions are made. To be eligible for this employer tax benefit, your cash balance plan generally must remain a “qualified” plan.

The way in which an employer’s tax deduction is calculated is generally more complex for a defined benefit plan (including a cash balance plan) than for a 401(k) or other defined contribution plan. In the case of a defined benefit plan, actuarial calculations are needed to determine benefits, liabilities, minimum funding requirements, and the maximum tax-deductible contribution under the plan, among other things. There are several possible methods that can be used to determine the employer’s maximum tax-deductible contribution to the plan for any year. You should consult a tax advisor or retirement plan specialist for further guidance.

OTHER ADVANTAGES OF CASH BALANCE PLANS

The plan offers guaranteed pension benefits for employees

This is the key similarity between cash balance plans and traditional pension plans. Each participant ultimately receives a dollar amount guaranteed under the plan, payable upon retirement (or possibly upon termination of employment) as either a lump sum or an annuity.

As a result, participants enjoy the security of knowing that their retirement benefits are virtually guaranteed — a feature not associated with 401(k)s and other defined contribution plans, where the final payout is based largely on investment performance. The insurance provided by the Pension Benefit Guaranty Corporation (PBGC) adds further security to these arrangements (see below). You, as the employer, pay these PBGC premium insurance costs.

The plan offers unique incentives to attract and retain employees

In addition to the security of guaranteed benefits, a typical cash balance plan offers certain advantages for your participating employees. These generally include portability, or the ability of participants to roll over their vested benefits to another retirement plan or to an IRA if they leave your service. Also, the fact that participants accrue benefits evenly throughout their employment (using a fairly simple formula, in most cases) and can see their “accrued benefits” at any time eliminates much of the complexity associated with traditional pensions, making cash balance plans easier to understand. In addition, many younger employees may like the idea of being rewarded at the same rate throughout their employment, because it puts them on more of a par with older, higher-paid employees.

Your business has some flexibility with contributions to hypothetical accounts

A cash balance plan is similar to a traditional pension plan in that both “define” future retirement benefits, not employer contributions. As a result, cash balance plans are not subject to the strict annual contribution limits that govern defined contribution plans. This generally means that you can contribute more to the plan than you would be able to contribute to a defined contribution plan. You also have some flexibility in terms of the formula for determining how much you credit for contributions to participants’  hypothetical accounts. The amount credited is usually either a percentage of the participant’s pay, or a flat dollar amount. The credits may also be age- or service-related in some cases. Some employers even credit different amounts for different components of pay, or base the credits on company performance.

The plan may be less difficult and expensive to maintain than other plans

The administrative costs of a cash balance plan may sometimes be lower than under a traditional pension plan, because it is likely that many cash balance plan participants will receive a lump-sum payout at termination or retirement. Once the participant receives a lump-sum payout, you have no additional responsibility, including no responsibility to provide a cost-of-living adjustment (COLA) for benefits to keep pace with inflation. By contrast, the majority of participants in a traditional defined benefit pension plan will receive a monthly annuity payout at retirement, requiring large numbers of checks to be cut. Also, traditional pension benefits often include a COLA, resulting in additional costs to you.

In some cases, a cash balance plan may even be less difficult and costly to maintain than a 401(k) or other defined contribution plan. Record keeping will be easier because there is no reconciliation required with trust assets, and because there are no employee contributions to be taken into account.

Because records of individual plan accounts must be kept, record-keeping costs associated with a cash balance plan may be higher than under a traditional pension plan. Also, while a traditional pension plan generally allows you to defer payment of benefits until employees retire, a cash balance plan generally allows terminating employees to take their vested benefits with them (i.e., cash out or roll over the benefits). Then benefits remain in a traditional pension plan until employees retire, you are generally able to keep the earnings on that money. For these reasons, a cash balance plan is sometimes not more cost-efficient than a traditional pension plan. The point is that overall cost efficiency depends on several factors that may vary from one situation to the next, so it is best to consult a retirement plan specialist as to whether a cash balance plan  will save you money versus a traditional pension plan or other type of plan.

You receive the benefit if investments perform better than expected

In other words, if you promise to credit each participant’s hypothetical account with 3% annual interest, but the plan’s underlying investments earn 8% each year, the 5% difference is yours to retain and use. If the earnings on plan assets are higher than needed or expected, the employer may take advantage of the surplus by reducing future funding contributions to the plan, or by increasing the retirement benefits to be paid to
participants.

You, as the employer, also bear the risk of any losses relating to plan investments. If those investments fail to achieve the interest rate needed, you must take steps to make up the difference.

Creditor protection

Funds held in a cash balance plan are fully shielded from your employee’s creditors under federal law in the event of the employee’s bankruptcy. If your plan is covered by the Employee Retirement Income Security Act of 1974 (ERISA), plan assets are also generally fully protected under federal law from the claims of both your employees’ and your creditors, even outside of bankruptcy (some exceptions apply). State law may provide additional protection.

Benefit calculation may mean less benefit funding than typical traditional pension plan

Cash balance plan retirement benefits are largely based on a straight percentage of each participant’s compensation. By contrast, a traditional defined benefit pension plan’s formula for calculating benefits may weigh more heavily a participant’s highest-earning years prior to retirement, and total years of service. Consequently, some employers can save significantly on benefits paid under a cash balance plan.

DO RESEARCH AND GET ADVICE FROM EXPERTS

At Kuderer Financial we clarify Cash Balance Retirement Plans for both employers and employees. Contact us to setup a complementary meeting to review your needs and questions.

Prepared by Broadridge Investor Communication Solutions, Inc.