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Interest Credits and Cash Balance Plans
Cash balance plans continue to grow in popularity, especially among businesses with multiple shareholders. A cash balance plan is a defined benefit plan that looks like a defined contribution plan, but with substantially higher contribution limits and different sharing of the investment risk. In a cash balance plan, a hypothetical account balance is maintained for each participant. Each year this account balance is credited with employer contributions (Pay Credits) and interest (Interest Credits), which are defined in the plan document. When a participant is entitled to receive a distribution, the amount is equal to the vested balance in the participant’s hypothetical account (so, from the participant’s standpoint, there’s nothing “hypothetical” about the account).
In 2010, the IRS issued both final and proposed regulations pertaining to the design and operation of cash balance plans, including the sections related to acceptable interest crediting rates. Choosing an Interest Credit that best meets the employer’s objectives is one of the most important steps in establishing a new cash balance plan. It’s especially important since “anti-cutback” rules prevent the plan from lowering the interest crediting rate on accumulated benefits.
A list of the permissible interest crediting methodologies can be found in Exhibit A to this paper. In general, the alternatives fall into the following categories:
- A fixed rate of not more than 5.0%.
- A rate tied to a recognized fixed income product, such as 10-year Treasury bill yields.
- A rate tied to a mutual fund, such as the return on an indexed fund like the Vanguard 500.
- The actual return on a diversified investment portfolio.
Depending on the general category, an annual maximum, reduction, minimum and/or spread may be available, leaving us with a complex web of potential acceptable alternatives.
There are three key considerations to take into account when selecting the interest crediting rate:
- Predictability of results. This allows annual contributions to more closely approximate the annual pay credits and avoid potential problems that can arise from material over or under funding. This can be accomplished either by designing the investment strategy to match the interest credit rules, or the other way around. For example, if the Interest Credit is tied to a mutual fund and you invest plan assets in that same fund, your interest credits and actual returns would be exactly matched, except for the effect of any minimums or maximums on the Interest Credit and the effect of timing of the contributions.
- Ease of administration. The potential intricacies of some of the alternatives are likely to lead to higher administration costs and carry greater risk and liability for error. For example, certain methodologies require that the cumulative return for each participant be non-negative. Keeping track of that cumulative minimum introduces a whole new set of recordkeeping challenges and questions.
- Reliability of compliance testing results. In most cash balance plans, the optimum plan design involves setting up multiple contribution tiers, with generally higher contributions for the business owners and minimal contributions for staff. This kind of design must be tested to assure compliance with many parts of the Internal Revenue Code (IRC), including Sections 401(a)(4) – nondiscrimination, 401(a)(26) – minimum participation, 415 – maximum benefit payout, 436 and 401(a)(4) – restrictions on payments of lump sums, 411(b) – accrued benefit requirements and sometimes 416 – top heavy minimums.
While the first two considerations may seem more obvious, the third is often paramount, especially when the plan design is bumping into the limits of one or more of the compliance tests, as is often the case. For example, suppose a plan has an interest crediting rate that varies from one year to the next. The plan may pass nondiscrimination testing in Year 1 when the Interest Credit is 4%. However, if the Interest Credit for year 2 is 7%, nondiscrimination testing may fail and cause the plan sponsor to pay more for staff benefits to correct the failure. This kind of uncertainty can be problematic for most plan sponsors.
Taking all this into account, we expect to recommend one of the following most of the time:
- A fixed rate of between 3% and 5%. Obviously, this is both simple and stable, making it easy for the plan to avoid unpleasant surprises and predictably satisfy required compliance testing. Where in this range the plan sponsor sets the fixed rate will depend on their appetite for risk and reward.
- The lesser of 5.5% or the third segment of the 24-month average yield curve. This will result in a crediting rate of 5.5% most of the time and, since IRC 415 maximums are based on 5.5%, it minimizes the chance of interest credits resulting in an account balance that is larger than what IRC 415 allows the plan to pay.
- The actual return on invested assets, within a collar. One of the surprises with the 2010 regulations was the fact that it allowed plan sponsors to set the Interest Credit equal to the actual return on plan assets, so long as those assets are reasonably diversified. On the face of it, this appears to be a wonderful option, since there will never be a mismatch between hypothetical accounts and invested assets. The catch is that very high or very low returns can throw a wrench into compliance testing. To counter this, we suggest applying a collar (e.g. – the Interest Credit will equal the actual return on assets, but no less than 1% and no greater than 6% in any given year). Before committing to this structure, we would “stress test” for compliance at the lower and upper ends of the collar to ensure that compliance testing issues will be unlikely.
This approach makes the job of the investment advisor easier: Rather than trying to hit a fixed return every year, they’re just trying to hit a return that falls somewhere within the collar. We’ll note that the 2010 regulations don’t specifically allow for an annual minimum. However, we have submitted several plan documents with this collar to the IRS, and they have all received favorable determination letters.
Every situation is different, both in terms of employer objectives and employee demographics. Your IAI consultants are ready to help you navigate the rules and strategies to find the rate that best fits your company.
List of Interest Crediting Methodologies
- A fixed, constant rate of not more than 5.0%. *
- The rate of return on an annuity contract for the employee, provided the contract is not structured to provide a crediting rate that is greater than a market rate of return.
- Yield on Treasury Bills, Bonds or Constant Maturities, plus an optional margin of up to 175 basis points, depending on the duration of the instrument. The shorter the duration, the bigger the margin.
- A corporate bond yield, as represented by any of the yield curve segment rates either averaged over the prior 24 months, as is required for funding calculations, or for a single month.
- A cost of living index plus an optional margin of up to 300 basis points.
- The actual return on plan assets. Annual returns can be either positive or negative, but the cumulative return cannot be negative. A plan providing interest credits based on actual return is subject to rules requiring diversification of investments and minimization of risk.
- An RIC (Registered Investment Company) rate of return. This is the return from a specific mutual fund, as long as the fund is not significantly more volatile than either the broad U. S. equity market or a similarly broad international equity market. Annual returns can be either positive or negative, but the cumulative return cannot be negative. *
- Any of the above, subject to a maximum.
- Any of the above reduced by some amount or procedure.
- Any of the above, with or without a maximum or reduction, subject to a minimum as follows:
- For alternatives 2 – 5, an annual minimum of not more than 4.0%.
- For alternatives 6 – 7, a cumulative minimum of not more than 3.0%. *
Final and Proposed Regulations Issued October 18, 2010. Those with asterisks are from the proposed regulations.
While still not final, a plan sponsor can rely on them for good faith compliance.
This article was written by Steve Diess, EA, MAAA. Steve is an IAI owner and consultant. He specializes in defined benefit plan design, retiree medical plan consulting, and public and private employer accounting for pension and OPEB plans.