Cash Balance Plans - How Do They Work?

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.

Caution: Generally, the maximum amount of compensation that a cash balance plan can take into account in determining the pay credit for a participant in 2019 is limited to $280,000 (up from $275,000 in 2018).

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."

Caution: 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).

Caution: 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

Caution: 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 2019, payable as an annuity commencing at age 62, to 100% of the participant's highest average compensation for a three-consecutive-year period or $225,000, 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.

Tip: 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 lump-sum 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 lump-sum 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.