The design of a retirement plan program requires a thorough analysis of the needs and resources of the client as well as a careful analysis of the options available under various types of plans. Too often, plan design for a small employer involves a 401(k) plan with consideration given only to whether or not to make a matching contribution. A proper plan design should consider the full-range of options available. These options include defined benefit plans as well as defined contribution plans.
The differences between defined benefit and defined contribution plans have given rise to several "hybrid" plan designs. A hybrid plan design combines some of the features of a defined benefit plan with some of the features of a defined contribution plan. One such hybrid plan is a cash balance plan.
A cash balance plan is a defined benefit plan that provides benefits to employees by reference to a hypothetical account balance. Contributions to the hypothetical account are based on a percentage of compensation, a multiple of age and service points, or other objective criteria. In addition, the hypothetical account is credited with interest based on an amount defined in the plan. A participant's benefit at retirement will equal the accumulation of such credits at retirement. Thus, a cash balance plan is designed to look like a defined contribution plan, with contributions and earnings credited to a participant's account, but has the promised-benefit feature of a defined benefit plan through the promised contribution and earnings credit.
Defined Contribution Plan Characteristics
Employers and participants often prefer a defined contribution plan because it is easy to understand the benefits they provide. With a profit sharing plan for example, a participant receives an allocation, usually a percentage of his or her compensation, which is invested and increases or decreases based on the returns of such investment. A cash balance plan is similar. Each year, a participant receives a hypothetical contribution to his or her account based on his or her compensation for that year, or some other objective criteria. The account accumulates with interest each year, as defined in the plan document. A simple cash balance plan could provide hypothetical contributions each year of 5 percent of pay and hypothetical interest credits of 5 percent. In such a plan, a participant's hypothetical account balance growth is illustrated on the following chart.
| Year | Salary | Contribution | Interest | Balance |
| 2002 | $20,000 | $1,000 | $0 | $1,000 |
| 2003 | $23,000 | $1,150 | $50 | $2,200 |
| 2004 | $25,000 | $1,250 | $110 | $3,560 |
| 2005 | $28,000 | $1,400 | $178 | $5,138 |
| 2006 | $30,000 | $1,500 | $257 | $6,895 |
| 2007 | $33,000 | $1,650 | $345 | $8,890 |
| 2008 | $40,000 | $2,000 | $444 | $11,334 |
An important part of any retirement program is helping employees to understand the value of their benefits under the plan. A cash balance plan helps employees see something they are already familiar with, an account balance. In contrast, traditional defined benefit plans are often misunderstood by employees because many do not understand the value associated with a monthly benefit payable at retirement age. Furthermore, even fewer understand the accrual of such a benefit through their career and the current value of such benefit.
Defined Benefit Plan Characteristics
While the benefits provided participants is similar to a defined contribution plan, a cash balance plan is a defined benefit plan. Thus, it has many of the characteristics of a traditional defined benefit plan. For example, benefits must be definitely determinable. This is accomplished in a cash balance plan by defining the contribution credits and interest credits in the plan document. Thus, unlike a profit sharing plan, contributions are actuarially determined and not made at the employer's discretion.
Like the sponsor of a defined benefit plan, the sponsor of a cash balance plan assumes the plan's investment risks. Since the interest credits to a participant's hypothetical account are defined in the plan document, the investment risk is borne by the employer. To the extent actual investment returns exceed or fail to meet such hypothetical credits, the sponsor must decrease or increase contributions accordingly.
Cash balance and traditional defined benefit plans differ in one major way. A traditional defined benefit plan typically defines the benefit at retirement as a function of average monthly compensation or service, or both. This benefit is usually payable for the participant's lifetime on attainment of the plan's retirement age. In contrast, a cash balance plan defines the benefit at retirement as an accumulation of contribution credits and interest credits at retirement age, which is usually payable as a lump sum. To illustrate this difference, consider the following example.
A defined benefit plan has a benefit formula of 2 percent of final three-years average pay times years of service. An employee with 35 years of service and $20,000 average compensation will receive $14,000 a year on reaching retirement age (2% x $20,000 x 35). An actuarially equivalent lump-sum benefit at retirement would be approximately $138,000. If instead the employer sponsored a cash balance plan providing a 5 percent of compensation credit for each of the employee's 35 years of service, the employee would have an account balance at retirement of $140,000 (if the plan provided a 7 percent interest credit).
The "defined benefit plan" status of a cash balance plan is evident in the calculation of a participant's benefit in the event the participant is eligible for and elects a distribution prior to the attainment of the plan's retirement age. This would often be the case if the plan provides for a distribution upon a participant's separation from service. In a defined contribution plan, the participant would be entitled to the vested value of his or her account balance. However, as a defined benefit plan, the calculation under a cash balance plan is more complicated.
A distribution from a cash balance plan of a participant's benefits must be the actuarial equivalent of the value of such benefits at such participant's retirement age. Assume for this example that the participant discussed in the prior section terminated employment at age 35 in 2008. The participant would not simply receive the $11,334 hypothetical account balance. In general terms, the amount of the lump sum distribution would calculated as follows:
Many cash balance plan sponsors are surprised to learn of the increased amount payable upon distribution, in this case, $1,829. The disparity is commonly referred to as a "whipsaw." In some situations, the disparity can be even greater (e.g., if the plan's interest rate was 8%, the present value would be $30,451, 268% higher than the accumulated hypothetical account).
The increased amount payable to the participant as a result of the whipsaw will increase the employer's funding requirement under the plan. There are generally two ways to avoid the whipsaw. First, cash balance plans can be designed to not provide for distributions prior to retirement age. This will avoid the issue all-together. Second, the interest credit provided in the cash balance plan could be defined by reference to the rate set forth in the Code to calculate present value for distribution purposes (i.e., if the present value rate equaled the plan's interest credit rate, the participant's distribution would match his or her hypothetical account balance). Careful consideration must be paid to this decision in the plan design process.
Like other defined benefit plans, cash balance plans are generally subject to the guarantees and obligations of the Pension Benefit Guaranty Corporation. In addition, contributions are actuarially determined. Thus, contributions will vary from the total of the hypothetical allocations due to investment returns and actuarial assumptions.
Designing a Cash Balance Plan
As with any plan, the most significant design decision is the allocation or benefit formula. A cash balance plan is no different. There are generally four design parameters to consider with any plan:
- the formula must satisfy the Code's non-discrimination requirement;
- allocations on behalf of any one participant must not exceed the maximum allowed under the Code;
- the contribution must be in an amount which is deductible by the employer; and
- the allocation formula must satisfy the Code's top-heavy minimum contribution requirement, if applicable.
For purposes of illustrating the design considerations of a cash balance plan, throughout the remainder of this article, I will refer to the following employee census:
|
Sample Employee Census |
||
| Employee | Age | Compensation |
| HCE1 | 60 | $200,000 |
| HCE2 | 57 | 200,000 |
| NHCE1 | 31 | 40,000 |
| NHCE2 | 26 | 40,000 |
Non-discrimination. As discussed above, a cash balance plan's allocation formula must be non-discriminatory. In this regard, the hypothetical allocations provided under a cash balance plan's benefit formula will be considered non-discriminatory if the formula either: (i) is determined according to a uniform hypothetical allocation formula; or (ii) satisfies a modified general test.
A uniform hypothetical allocation formula generally includes a "pro-rata" allocation formula, under which each participant receives an allocation of the same percentage of compensation, and an "integrated" allocation formula, under which each participant receives an allocation of the same percentage of compensation plus an additional allocation with respect to compensation earned in excess of the taxable wage base (the compensation level at which contributions to social security cease). These allocation formulas are similar to those frequently utilized in profit sharing and money purchase plans. In general, the following illustrates the results of a uniform allocation formula with respect to our sample company:
| Uniform Allocation Formulae | |||
|
Employee |
Compensation |
Pro-Rata |
Integrated |
|
HCE1 |
$200,000 |
$10,000 |
$15,755 |
|
HCE2 |
200,000 |
10,000 |
15,755 |
|
NHCE1 |
40,000 |
2,000 |
2,000 |
|
NHCE2 |
40,000 |
2,000 |
2,000 |
Often, the greatest design flexibility occurs through a formula that does not constitute a uniform allocation formula, but rather, satisfies the modified general test. The general test permits the employer to design an allocation formula which best fits the employer's workforce. The formula must be based on objective classifications and the resulting allocation must satisfy a mathematical non-discrimination test. The test is computed, however, after imputing social security benefits and age-based factors. This is similar to a "new comparability" profit sharing plan which relies on the same mathematical test to satisfy the Code's non-discrimination requirements.
While the workings of the general test are beyond the scope of this article, the test will generally permit greater allocations, as a percentage of compensation, to a group of employees who, as a group, are older than the group of employees receiving lesser allocations. The disparity permitted in an individual case depends upon the employee census.
If we assume our sample company wishes to provide a greater allocation for partners, the disparity permitted in a cash balance plan is illustrated by the following plan design. This design would provide a hypothetical allocation of 50% of compensation for partners and 7.5% of compensation for non-partners. The hypothetical allocations would be as follows:
| Modified Allocation Formula | |||
| Employee | Compensation | Allocation | Percent of Compensation |
| HCE1 | $200,000 | $100,000 | 50% |
| HCE2 | 200,000 | 100,000 | 50% |
| NHCE1 | 40,000 | 3,000 | 7.5% |
| NHCE2 | 40,000 | 3,000 | 7.5% |
This design would satisfy the general test based on these facts. Thus, it is a permissible formula in a cash balance plan.
As with any plan design, the design of the cash balance plan must be reviewed on an annual basis. This is especially true if an allocation formula is utilized which satisfies the non-discrimination requirements by satisfying the general test. Any change in the company's workforce could have a significant effect on whether the formula will continue to satisfy the general test.
To further illustrate the design flexibility, assume that HCE1 owns the business and HCE2 is merely a highly-paid employee. The company may wish to design a plan providing greater contributions to HCE1 and lesser contributions to HCE2. A cash balance plan could provide a formula which provided a hypothetical allocation of 60% of compensation for senior partners, which includes only HCE1, and 7.5% of compensation for all other employees.
As discussed above, in addition to the hypothetical allocation, the cash balance plan must provide an earnings credit which is applied to each participant's hypothetical allocations. The interest credit provided under a cash balance plan need not be a "set" interest rate but is often defined by reference to an index or security. No matter how the interest credit is defined, careful attention must be paid to three issues. First, it must be determined that a prudent investment strategy will be able to attain such results. Sponsors must keep in mind that contributions are actuarially determined and not merely the sum of the hypothetical allocations for a year. This can be a significant problem if the interest credit applied by the plan exceeds the earnings the plan's actuary is willing to assume in calculating a year's funding requirements. To the extent the plan's interest credit exceeds the actuary's assumed earnings rate, the funding required by the employer will be increased. Second, to the extent the interest credit exceeds the actual investment return obtained on plan assets, additional employer contributions will be required. Third, as discussed above, if the plan's interest credit rate exceeds the permissible present value calculation rate, distributions prior to retirement age will be in amounts in excess of participants' hypothetical account balances. This will require additional employer funding.
Section 415 Limits. A participant's allocation to any plan are limited by Section 415 of the Code. With respect to a defined contribution plan, allocations cannot exceed the lesser of $40,000 or 100% of a participant's compensation. Thus under a profit sharing plan, for example, no participant could receive an allocation in any given year in excess of $40,000, even if the employer was willing to make larger contributions.
A cash balance plan is a defined benefit plan. The section 415 limit for a defined benefit plan is an annual benefit commencing at retirement age which does not exceed $160,000. Accruals for a specific plan year are limited to an amount necessary to fund the retirement benefit. For example, a 57 year old can, under certain circumstances, receive an accrual in excess of $148,000 for a plan year, without exceeding the limits of section 415. Thus, the benefits which can be provided under a cash balance plan generally exceed that which could be provided under a defined contribution plan.
Deduction Limits. The Code limits an employer's deductions for contribution to a plan. Contributions to a defined contribution plan are deductible to the extent they do not exceed 25% of compensation otherwise paid to participants. In contrast, contributions to a defined benefit plan are deductible to the extent they do not exceed the section 415 limit discussed above.
Cash balance plans are often considered by companies sponsoring new comparability plans. The similarities between these plans makes this an obvious progression.
However, sponsoring both plans raises a deduction issue. Specifically, if a company attempts to deduct contributions to a defined benefit plan and a defined contribution plan, the company's deduction is limited to the greater of the minimum funding required by the defined benefit plan or 25% of compensation otherwise paid to participants. This limit must be carefully considered.
If the deduction limit does allow contributions to both plans, an important factor to consider is that the Section 415 limit can be provided to an employee under both plans. Thus, an employee can get $40,000 under the defined contribution plan and whatever amount is permitted under the defined benefit plan.
Section 401(k) contributions are not limited by the deduction limit. Thus, a company could sponsor a cash balance plan which requires contributions in excess of 25% of compensation otherwise paid to participants. These contributions are fully deductible because the joint plan limit does not apply. Also, the joint plan limit will not apply if the company sponsors a defined contribution plan which permits only 401(k) deferrals. No match or profit sharing can be made, however, without triggering the joint plan limit.
Top-heavy Rules. The plan design last set forth above would no doubt result in the plan constituting a top-heavy plan under the Code. The Code's top-heavy minimum allocation requirements would require that the accrued benefit on behalf of NHCE1 or NHCE2, the non-key employees, must be at least 2% of compensation. Generally, this is calculated as follows.
- determine the hypothetical allocation to each non-key employee this plan year, $2,000 each for NHCE1 and NHCE2;
- calculate the value of that amount at retirement age (65) using the plan's interest credit rate (5%):
NHCE1 = $2,000 x (1.05)65-31 = $10,507
NHCE2 = $2,000 x (1.05)65-26 = $13,410
- calculate the "accrued benefit" by converting to a life-annuity using the plan's annuity purchase rate (assume 10):
NHCE1 = $10,507 ÷ 10 = $1,051
NHCE2 = $13,410 ÷ 10 = $1,341
- determine if the accrued benefit equals the top-heavy minimum accrued benefit (2% of current compensation, $800 for NHCE1 and NHCE2).
In this case, the accrued benefit provided by the hypothetical allocation exceeds the top-heavy minimum. Therefore, no additional allocation is required to satisfy the top-heavy minimum allocation requirement. However, in certain cases, the top-heavy minimum will require additional allocations. Specifically, older employees can require significant top-heavy minimum contributions.
Legal Status of Cash Balance Plans
Those who follow the pension industry may hesitate to consider a cash balance plan because many believe them to be overly aggressive or illegal in some way. This belief is caused by many news reports and lawsuits filed challenging the legality of such plans. However, those challenges concern company's converting traditional defined benefit plans to cash balance plans. Conversion can significantly reduce the future accruals of certain older employees. Thus, companies considering such a conversion should carefully study the applicable law. However, companies establishing new cash balance plans do not face the "conversion" issues. In fact, the Internal Revenue Service will review and issue determination letters with respect to new cash balance plans.
Conclusion
A cash balance plan combines many of the benefits of a defined contribution plan (e.g. the allocation formula of a new comparability profit sharing plan) with the advantages of a defined benefit plan (e.g. increased 415 and deduction limits). For this reason, a cash balance plan is something employer's should consider in the design of their retirement programs.
Keep in mind that results of a cash balance plan design depend greatly on the employee census of the adopting employer. A careful study of an employer's census is required prior to deciding to adopt a cash balance plan.
The adoption of a cash balance plan can have tremendous advantages for an employer. However, the employer must fully understand that a cash balance plan is a defined benefit plan. As such, contributions are actuarially determined and not in the discretion of the employer. Thus, the employer must carefully study the choice of a cash balance plan as well as its design.
George M. Morrison, Esquire is an employee benefits attorney with The Law Firm
of G.M. Morrison, P.C., in Cherry Hill, New Jersey. He is also President of Continental Benefits
Group, Inc., a third-party administrator of retirement plans.
Mr. Morrison received his Master of Laws in Taxation from New York University School of Law in 1995 and his Juris Doctorate from Rutgers University School of Law at Camden in 1994. Mr. Morrison published several articles on retirement plan topics and lectures frequently on issues concerning tax-qualified and non-qualified retirement plans.
G.M. Morrison, P. C. and Continental Benefits Group, Inc. are able to assist companies in the design of a retirement program taking into consideration all available options. Our capacity as a law firm and TPA lends our clients the legal expertise to ensure plan's are designed properly and in accordance with all applicable laws. Please call us if we can of assistance to you.
© George M. Morrison, 2001 - 2003.