About Cash Balance Plans
Cash Balance Pension Plans
About Cash Balance Plans
A Cash Balance Plan is a type of tax qualified retirement plan. The contributions made to the plan are tax deductible and the investment return grows tax deferred. Participants do not pay income tax on their benefits in a Cash Balance Plan until distributed from the plan or a subsequent rollover IRA. The benefits and assets contained within a Cash Balance Plan are subject to ERISA creditor protection rules.
Cash Balance Plans are a type of a Defined Benefit Pension Plan. The plan benefits are defined in a written plan document and the plan requires the service of an enrolled actuary to calculate the minimum funding requirement and to certify the plan’s funding status to the plan sponsor and the IRS (and in some cases the Pension Benefit Guaranty Corporation) annually.
Cash Balance Plans are a suitable retirement plan for closely held businesses, self employed individuals, and professional firms. Cash Balance Plans enable a higher tax-deductible contribution level than is possible in a 401(k) Plan or other Defined Contribution Plan.
A Cash Balance Plan can be maintained along with and as a companion to a 401(k) Profit Sharing Plan. A Cash Balance Plan paired with a 401(k) Profit Sharing Plan often provides a more favorable contribution cost design than a stand-alone Cash Balance Plan.
Cash Balance Plan Benefits
A written plan document must govern a Cash Balance Plan. This plan document will provide for an annual allocation (usually a specific dollar amount or percentage of compensation). The plan document will also specify an interest crediting rate. Each participant will have a hypothetical account within the plan records that is adjusted each year based upon this annual allocation and specified interest crediting rate. When a participant terminates employment, their lump sum distribution or direct rollover to IRA is equal to the value of the hypothetical Cash Balance Plan account.
Interest Crediting Rate
For most Cash Balance Plans, the interest crediting rate will be defined as a fixed, historically low interest rate (usually 3% to 5%). The interest crediting rate should be set less than 5.50% so that the lump sum benefit limit (i.e., the maximum that can be distributed out of the plan to a participant without tax consequences) is not lower than the maximum allowed by law. Due to how the interest crediting rate affects the various non-discrimination tests, a lower interest crediting rate generally
results in higher employee cost. For this reason, an interest crediting rate of 5% is recommended. The interest crediting rate should be a fixed versus a variable interest crediting rate to avoid potential complications with respect to the testing of the Cash Balance Plan and a 401(k) Plan for combined IRS non-discrimination testing (i.e., to prevent surprises in the necessary employee contribution cost to pass this testing from one year to the next.)
Cash Balance Plan Funding
While the value of the Cash Balance Plan benefits is determinable at any point in time based upon the plan’s defined allocations and interest credit, the value of the assets will differ from the value of the Cash Balance Plan benefits.
Considering this feature of Cash Balance and Defined Benefit Plans, congress and the IRS permit plan sponsors a range of available contributions that can be made and deducted each plan year. This range goes from a minimum required contribution amount, calculated by the plan’s actuary, up to a maximum deductible contribution amount.
The annual actuarial valuation report will include information about the Cash Balance Plan’s available funding range, participant statements, and a summary of benefits provided by the plan.
The minimum required contribution amount will usually be less than the contribution amount that would fully fund the Cash Balance Plan benefits. This amount is calculated by the actuary based upon rules and assumptions prescribed by IRS and certain assumptions selected by the actuary, considering the value of the plan benefits, the value of the plan assets, and the ages of the participants.
The actuarial valuation report will also outline the contribution amount to fully fund the Cash Balance Plan benefits.
The maximum deductible contribution amount is usually greater than the contribution to fully fund the Cash Balance Plan. With certain assumptions, a plan sponsor can fund a Cash Balance Plan up to the point where the value of plan assets is equal to the sum of 150% of the value of the benefits earned as of the beginning of the year plus 100% of the value of benefits earned during the year. The exceptions are:
1. In the first year of the plan, the maximum deductible contribution amount is generally equal to the 100% funding amount (since there are not benefits earned in a prior year.)
2. If the total employer contributions to a companion 401(k) Profit Sharing Plan are more than 6% of total participant compensation, the maximum deductible contribution to the Cash Balance Plan could be limited such that total employer contributions are not more than 31% of total participant compensation.
3. If the plan sponsor is a sole proprietorship or partnership, the total deductible contribution amount cannot exceed net earnings from self employment.
To be deductible for a tax year, the contribution amounts must be made by the due date of the business tax return including any periods of extension (but no later than 8.5 months after the end of the plan year). The plan sponsor can fund a Cash Balance Plan on a monthly or quarterly basis or can make one contribution in total each year.
Managing Plan Funding
When a company sponsors a Cash Balance Plan, It is important for the plan sponsor, financial advisor, CPA, third party administration firm and actuary to communicate with each other when there are changes in the desired contribution amount, relevant changes in the business cash flow, when the plan sponsor is considering retirement or sale of business, when plan assets are getting close to the fully phased in maximum benefit limit, or when employee demographic changes could materially change the combined plan employee contribution cost. This will ensure that necessary changes to the plan are made timely.
There is always a range of available contributions from the minimum required contribution up to the maximum deductible contribution.
Additionally, a plan sponsor can amend the plan up until 2.5 months after the plan year-end (March 15th for calendar year plans) to increase benefits and funding range.
A plan can be amended to freeze allocations or to lower benefit allocations before participants work 1000 hours during a plan year (generally around May or June for calendar year plans).
Note, in most cases a plan sponsor is not required to fully fund a Cash Balance Plan. Upon Plan Termination, the non-owner participants must receive the full value of their benefits. However, a majority owner of the plan sponsor can receive a lower distribution amount based upon remaining plan asset amount in lieu of full funding their benefit amount.
Additionally, as the plan asset return will vary from the interest credit from year to year, it may make sense to amend the Cash Balance Plan allocations periodically to adjust for this difference. For example, a plan sponsor may amend the Cash Balance Plan to increase benefit allocations to “soak up” overfunding if the plan assets become significantly greater than the value of plan benefits. A plan sponsor may amend to decrease benefit allocations if the plan assets become significantly less than the value of the plan benefits.
Cash Balance Plan assets are generally held in a single investment pool. The participant direction common in 401(k) Profit Sharing Plans is not applicable or available in a Cash Balance Plan.
The investments can be held in an investment brokerage account or with a retirement plan platform provider. The assets can be any combination of stocks, bonds, mutual funds, ETFs, cash, money market, options, etc. Any investment whose value is readily determinable and is within jurisdiction of U.S. courts can be held by a Cash Balance Plan.
Considering that the plan’s benefits grow by a defined interest crediting rate, the plan is subject to minimum funding requirements affected by plan asset return, non-owner employees must receive the full value of their benefit when distributed, and the maximum amount that can be distributed and rolled over to an IRA is subject to maximum benefit limits, Cash Balance Plan assets often utilize a moderately conservative investment strategy.
Maximum Benefit Limits
The maximum amount that can be distributed out of a Cash Balance Plan to a participant without tax consequences is limited by law. The IRS publishes an annual maximum pension benefit amount. This maximum pension benefit amount is converted into a lump sum using IRS prescribed mortality tables and interest rates. The amount is phased in over the first ten years of plan participation. A second maximum lump sum is calculated that factors in the participant’s highest 3 consecutive years of compensation and the participant’s years of service. The smaller of these two calculations is the participant’s maximum distributable limit.
It is important for the actuary, third party administration firm, plan sponsor, CPA, and investment advisor to understand these maximum benefit limits as they apply to particular plan participants and have an expectation of when contributions will be scaled back or ceased in order to remain within these limits.
Why Cash Balance versus Traditional Defined Benefit Pension Plans
Cash Balance Plans are a type of Defined Benefit Pension Plan. Cash Balance Plans are an improved version of Defined Benefit Pension Plans are preferable for several reasons.
Communication – The benefits in a Cash Balance Plan are valued as lump sum account balances. Traditional Defined Benefit Plans value benefits as single life annuities. It is easier for a participant to understand their benefit value in a Cash Balance Plan.
Age Neutral Benefits for Employees – Cash Balance Plans can provide the same contribution rate to employees. This was not possible with traditional Defined Benefit Plans and often resulted in unfavorable contribution costs for certain employees.
Increased Flexibility – Cash Balance Plans provide more flexibility than traditional Defined Benefit Plans when it comes to allocations and contribution amounts.
Consistent Benefit Growth – The benefits in a Cash Balance Plan grow at a plan defined interest crediting rate. Cash Balance Plan benefits are not subject to volatile changes in value due to interest rate environment changes like the benefits in traditional Defined Benefit Plans were.
A Cash Balance Plan can provide for different benefit levels and contributions for owners, physicians, partners, and other key individuals. Plan Sponsors can give different benefit values to the various partners in a company.
Form 5500 Filing
A Cash Balance Plan is a qualified plan required to filing a Form 5500 each year. The plan’s third-party administrator or plan actuary will generally prepare the Form 5500 on the plan sponsor’s behalf.
When a Cash Balance Plan terminates, the non-owner participants must receive distributions equal to the full value of their benefit. For underfunded plans (plans with assets less than total plan benefits), majority owners (more than 51% of company ownership) can elect to forego receiving a portion of their benefit under the plan and receive remaining amount of plan assets. For companies with no majority owners, the owners may still be able to forego receipt of benefits. However, in some cases, the owners’ benefits may need to be fully funded to terminate the plan.
For overfunded plans (plans with assets greater than total plan benefits), the overfunding will be allocated to participants in a non-discriminatory manner. Most Cash Balance Plan documents stipulate that the overfunding will be allocated pro rata on participant’s benefit amounts.
Pension Benefit Guaranty Corporation
Some Cash Balance Plans are subject to coverage by the Pension Benefit Guaranty Corporation (PBGC). The PBGC is a governmental agency that insures participant benefits provided by private employer pension plans. If a plan is covered by the PBGC, the plan sponsor will be required to submit a PBGC premium filing each year and pay annual premiums to the PBGC.
Plans covering only owner employees or plans sponsored by professional service groups with less than 25 active participants are exempt from PBGC coverage. Professional service groups are offices of physicians, dentists, architects, actuaries, engineers, CPAs, attorneys, etc.
Plans that are covered by the PBGC must pay a fixed-rate premium of $86 per participant each year to PBGC. Underfunded Pension Plans may need to pay an additional variable-rate premium.
Plan Distribution Options
Since a Cash Balance Plan is a type of a Defined Benefit Pension Plan, the plan must offer participants the option to elect a distribution in the form of an annuity (life annuity, joint life and 50% survivor annuity, joint life and 75% survivor annuity, joint life and 100% survivor annuity). Although these options must be offered, almost all participants elect to take their distribution in the form of a lump sum or a direct rollover to an IRA or another qualified retirement plan.
If a participant elects a distribution in the form of an annuity, the Cash Balance Plan can pay the monthly annuity amounts to the participant or purchase an annuity for the participant from a life insurance company. If an annuity contract is purchased from a life insurance company, the plan would pay a single premium to the insurance company and the insurance company would take on the liability for making the monthly benefit payments to the participant.