By Stewart D. Lawrence, Sibson Consulting
Although cash balance plans account for a large percentage of defined benefit (DB) retirement plans covering new hires, the number of new cash balance plans had slowed to a trickle since the passage of the Pension Protection Act in 2006, largely because of the absence of clear regulations. While awaiting guidance, employers that wanted to move to an account-based or capital-accumulation plan but were concerned about the negative financial aspects of traditional DB plans—most notably cost level and cost volatility—had only one practical option: a traditional defined contribution (DC) plan, such as a section 401(k) plan or profit-sharing plan.
In late 2010, employers received much of the clarity they were waiting for about the design and structure of cash balance plans when the Internal Revenue Service (IRS) issued proposed and final regulations.
Proposed and Final Cash Balance Plan Regulations
On Oct. 19, 2010, the IRS released final and proposed rules for “hybrid” defined benefit plans—such as cash balance plans—that implement changes introduced by the 2006 Pension Protection Act:
• The final rules are generally applicable in the 2011 plan year, with certain provisions applicable in 2012.
• The proposed rules are scheduled to be generally applicable to the 2012 plan year.
The rules include the following issues: an age discrimination safe harbor, conversion from a traditional plan and the market rate of return requirement for interest crediting rates (to learn more, see the SHRM Online article "Proposed IRS Rules Expand Options for Cash Balance Plans").
As with all issues involving the interpretation or application of laws and regulations, plan sponsors should rely on their attorneys for authoritative advice on the interpretation and application of the final and proposed rules for hybrid plans.
-- Sibson Consulting
Now, there really are two viable choices for providing an account-based retirement plan: a traditional DC plan or a "hybrid" cash balance plan that capitalizes on the attractiveness of defined benefit and defined contribution plans.
Advantages for Employers
A cash balance plan is a DB plan where the basic benefit is expressed in terms of an individual account rather than a lifetime annuity payable at retirement. For example, a simple form of a cash balance plan would be one in which the nominal account equals 8 percent of each year’s pay, accumulating with interest equal to the rate on 10-year or 30-year Treasuries.
The potentially compelling reasons for employers to consider a cash balance plan are:
• Financial efficiency. A traditional DC plan is the approach to follow for employers that want to “set it and forget it” because the cost of the plan is fixed: X percent of pay. However, that certainty is not without a price in potential savings. In the simple cash balance plan described above, the apparent cost of the plan is 8 percent of payroll, but the expected economic cost of the plan can be much less. The source of this savings is the differential between the rate that a plan will credit on employee accounts (which is often the 10-year or 30-year Treasury rate) and the discount rate. Under funding and accounting rules, the discount rate is based on corporate investment grade bonds.
Given recent market conditions, this differential can create a 1 to 2 percent spread, resulting in a cost of approximately 6 percent of payroll for an employee assumed to retire in 20 years. This potentially saves as much as 2 percent of payroll each year (or more, if emerging investment performance exceeds the rate earned on corporate bonds), compared to a look-alike 8 percent DC plan. Of course, there is no guarantee that the return will earn more than the yield on a 10-year or 30-year Treasury. And, while that may indeed be a somewhat risky bet in any one year, over the long term that may be a risk worth taking to save 2 percent of payroll each year.
• Mitigating a significant financial risk compared to a traditional DB plan. A traditional DB plan is exposed to an investment risk (through its assets) and an interest-rate risk (through its liabilities). When the two risks go the wrong way—assets going down while liabilities increase—plan sponsors have experienced a “perfect storm.”
While a cash balance plan is a DB plan, under a typical feature where the annual interest credit is set at a market rate (e.g., 30-year Treasuries), the interest-rate risk on the liabilities is significantly muted without needing to introduce complex interest rate hedging techniques that one would need in a traditional DB plan. The reason for this is simply that whereas lower discount rates drive up a typical DB plan’s present value of future benefits (i.e., the plan’s liability), lower discount rates usually reduce a typical cash balance plan’s interest crediting rate, thereby offsetting the increase in the liability attributable to lower discount rates.
• Universal coverage. If employers shift the primary retirement vehicle from a traditional DB plan to a traditional 401(k) plan, one group of employees is left out in the cold: those who are unable to save money in the 401(k) plan and, therefore, receive no employer match. Although typically not a substantial portion of the population, it is nevertheless a group about which the HR department is often concerned. A cash balance plan fills this gap because, like a traditional DB plan, it covers all employees.
• Balance of risk. Many employers believe that their assumption of 100 percent of the financial risks of the retirement program is too far to one extreme. However, a growing number of employers think that having employees assume 100 percent of the risks goes too far in the other direction. A cash balance plan operating in tandem with a DC plan provides a reasonable middle ground.
• Benefit design flexibility. Because a cash balance plan is a DB plan, it can be used to meet employers’ personnel goals in ways that are not available to DC plans. For example, they can be (although not often are) the basis for providing early retirement windows and spousal benefits.
• Passing nondiscrimination testing. Many DB plan sponsors closed their DB program to new hires in the past few years. If this has not already created nondiscrimination problems, it is likely to do so in the future as the DB population ages and becomes higher paid. Redirecting a portion of current DC accruals into a cash balance feature in the DB plan (in effect allowing new participants into the DB plan) might make it easier to pass the nondiscrimination test for the closed DB plan.
Advantages for Employees
From the employees’ point of view, there are two main advantages of a cash balance plan:
• Preservation of investment principal. Cash balance plans typically provide a feature that DC plans do not provide under the commonly elected investment options: account values that can only increase from year to year. Essentially, cash balance plans act like stable-value funds providing a dependable floor of protection. Further, although the interest credit in a cash balance plan might seem conservative compared to traditional DC investments, participants could compensate for this conservatism by allocating a larger portion of their DC accumulation to equities.
• Longevity protection. Surveys have shown that one of the two major fears of employees who are about to retire is outliving their money. (The other is a medical catastrophe that wipes out savings.) Because a cash balance plan is a DB plan, it must offer the option of receiving a lifetime payout rather than a lump sum. To some extent, this serves as a floor of protection against outliving one’s money.
Given the new statutory and regulatory clarity and the potentially compelling reasons for considering cash balance plans, the number of cash balance plans is likely to increase—because of conversions from traditional DB plans (as a risk mitigation technique) and the redirection of a percentage of employer contributions from traditional DC plans (as a cost mitigation technique).
Stewart D. Lawrence is senior vice president and national retirement practice leader at The Segal Company and Sibson Consulting.
This article originally appeared in the March 2011 issue of Sibson Consulting's "Spotlight" and is reposted with permission.
U.S. Supreme Court Lets Stand Rejection of Age-Bias Claim
In another legal victory for sponsors of cash balance plans, on March 21, 2011, the U.S. Supreme Court declined to review a 2010 appeals court ruling in favor of a cash balance plan sponsor (Walker v. Monsanto Pension Plan). According to HR consultancy Mercer, the 7th U.S. Circuit Court of Appeals held the plan was not age-discriminatory even though participants stopped receiving interest credits on one of their accounts at age 55.
The 7th Circuit reasoned the interest credits were not benefit accruals; they merely restored early retirement discounts that would have applied had benefits started before age 55.
-- SHRM Online staff
Cash Balance Design: National Cash Balance Research Report, Kravitz, May 2011
New Regulations Likely to Impede Hybrid Plans, BNA's Pensions & Benefits Blog, April 2011
Investment Strategies for Cash Balance Plans—More Risk Than You Thought, Vanguard Investments, February 2011
Proposed IRS Rules Expand Options for Cash Balance Plans, SHRM Online Benefits Discipline, November 2010
Cash Balance Retirement Plans: They're Back!, SHRM Online Benefits Discipline, October 2007
Cash Balance Plans, SHRM Multimedia
SHRM Online Benefits Discipline