On September 19th the IRS issued both new proposed regulations and final regulations that update regulations originally issued in proposed form in 2010 covering Cash Balance and other hybrid pension plans. While the IRS did not address all questions left open by the 2010 regulations, the final regulations further strengthen the position of Cash Balance plans as the most rapidly growing new plan design for small and medium sized employers.
Interest Crediting Rate
A Cash Balance plan cannot credit more than a “Market Rate of Return” to a participant’s hypothetical account in the plan. The 2010 regulations provided some guidance as to what qualifies as a “Market Rate of Return.” For example, the 2010 regulations established a maximum fixed rate of return of 5%. The final regulations just released increase the maximum fixed crediting rate to 6%.
As an alternative to a fixed crediting rate, a Cash Balance plan can credit a participant’s hypothetical account with the “Actual Rate of Return” earned on plan assets. “Actual Rate of Return” means exactly what it one would think it means – the rate of return earned by the plan over the interest crediting period. The final regulations expand the application of the Actual Rate of Return to allow the employer to apply different investment strategies generating different Actual Rates of Return for different employee groups. For example, the plan could possibly apply a more conservative strategy with an expected lower, but more stable Actual Rate of Return for employees nearing retirement age.
This approach will likely be attractive to many employers, but we would caution that at this point there is not clear guidance as to how non-discrimination and other plan operation requirements would apply. It is also not clear when and from where such guidance will come.
A third Market Rate of Return approach used by some of our clients is to combine a minimum floor rate of return with a variable crediting rate such as government bond rate. The allowable minimum rate has been increased from 4% to 5%.
Other Changes Impacting Cash Balance Plans
The final regulation address (favorably) issues related to the ability of a Cash Balance plan to offer subsidized early retirement benefits and alternative forms of distribution. The proposed regulations provide guidance for the plan sponsor transitioning from a noncompliant interest crediting rate to one acceptable under the final regulations. In particular the regulations provide limited anti-cutback relief when the interest crediting rate of reduced. The IRS has asked for comment on the transition guidance.
It wasn’t that long ago that issues surrounding Cash Balance and other hybrid pension plans had to do with whether or not they had a place in the U.S. pension system. These latest regulations, very much fine tuning in nature, are further affirmation that Cash Balance plans are now a mainstream plan design, and growing in popularity.
As with the promulgation of any set of new and finalized regulations, the pension industry will now digest both the intended and unintended consequences of the regulations and where appropriate test the limits of new plan design. We expect that a likely trend will be for Cash Balance plan sponsors to consider tweaking their interest crediting approach to take advantage of the opportunities created by the new regulations.
For questions you might have about an existing or potential cash balance plan, please contact an IAI consultant.