View the online version at http://us.practicallaw.com/5-597-5026 Market-Based Cash Balance Plans BRIAN C. DONOHUE, OCTOBER THREE CONSULTING LLC, WITH PRACTICAL LAW EMPLOYEE BENEFITS & EXECUTIVE COMPENSATION This Article provides an overview of the marketbased cash balance plan, a type of hybrid retirement plan that provides returns in the form of interest credits that are similar to the returns provided by a defined contribution plan. There has recently been a modest increase in the number of defined benefit plans sponsored by law firms and small employers. Given the widespread movement away from traditional defined benefit plans, this might be surprising. However, this trend is driven by an increase in hybrid defined benefit plans, such as market-based cash balance plans, while traditional defined benefit plans continue to decline. Market-based cash balance plans have increased in popularity because they can produce stable costs, like defined contribution plans, while index-based cash balance plans can be more prone to cost volatility. The Pension Protection Act of 2006 (PPA) provided the basis for market-based cash balance plans. Before the PPA, cash balance plans produced many of the same problems for employers as traditional defined benefit plans because a participant's hypothetical account was not tied to the plan's underlying assets, so fluctuations in investment returns could mean volatile employer costs. Under market-based cash balance plans, investment returns flow through to participant account balances, so employer costs are more stable, like defined contribution plans. This Article provides an overview of market-based cash balance plans. In particular, it: Defines a market-based cash balance plan. Explains the market rate of return and the preservation of capital rules. Discusses the benefits and drawbacks of market-based cash balance plans. Discusses the how market-based cash balance plans are valued. Describes the types of companies that are implementing marketbased cash balance plans. CASH BALANCE PLANS A cash balance plan is a hybrid defined benefit plan that defines a participant's benefit in terms of a hypothetical account. It includes the sum of: A pay credit based on a percentage of the participant's current pay. An interest credit based on hypothetical earnings on that account at a rate specified in the plan. Pay credits are calculated similarly to employer contributions in a defined contribution plan, while interest credits are intended to mimic actual earnings in a defined contribution plan. Distributions are typically taken as a lump sum equal to the balance in the participant's hypothetical account at termination of employment, although, unlike most defined contribution plans, annuity options are also available. (See Practice Note, Cash Balance Plans: Basic Principles of Cash Balance Plans (http://us.practicallaw.com/4-525-6649).) MARKET-BASED CASH BALANCE PLANS AND APPLICABLE LAW Final and proposed hybrid plan regulations under Sections 411(a)(13) and 411(b)(5) of the Internal Revenue Code (IRC) were issued in 2010 and 2014. Under these rules, a cash balance plan may use marketbased interest credits based on the actual rate of return on actual investments if the plan's assets are diversified (as required under ERISA Section 404(a)(1)(C) (29 U.S.C. 1104(a)(2)) to minimize the volatility of returns.
For example, if a plan provides annual pay credits of 5% of pay and interest credits based on actual trust returns, a participant making $50,000 would earn a $2,500 pay credit. If plan assets earn 6% during the year, the account would be worth $2,650 ($2,500 times 1.06) at year-end. Interest credits can be: Lower than the trust rate of return (for example, 90% of the trust return, or the trust return minus 1%), but not greater, and they are subject to the preservation of capital minimum (see Preservation of Capital Rule). This lets employers recover overhead plan costs, including the cost of providing the required minimum benefit. Based on one subset of plan assets appropriate for active employees while pursuing a de-risking or bond portfolio for current retirees. Based on returns on a combination of mutual funds, which may be more transparent to participants while still allowing employers to hedge the promise by investing in these same funds. These provisions permit a cash balance plan to provide returns in the form of interest credits that are similar to the returns provided by a defined contribution plan, as shown in the example. The trust returns flow to the participant's bottom line and not the plan sponsor's. The hybrid plan regulations also impose a market rate of return requirement (see Market Rate of Return Rule) and preservation of capital rule (see Preservation of Capital Rule) for market-based cash balance plans. MARKET RATE OF RETURN RULE The market rate of return rule provides that the interest crediting rate under a market-based cash balance plan cannot be greater than a market rate of return. The regulations describe a list of rates that satisfy this requirement. The interest crediting rate can be based on the greater of two interest rates if certain interest rate floors or minimums apply (see Practice Note, Cash Balance Plans, Market Rate of Return Rules (http://us.practicallaw.com/4-525-6649) and see Cumulative Floor Safe Harbor). PRESERVATION OF CAPITAL RULE The preservation of capital rule provides that a participant's benefit under a market-based cash balance plan, determined as of the participant's annuity starting date, may be no less than the sum of: The pay credits. Any opening balance. Any amounts resulting from plan amendments. (See Practice Note, Cash Balance Plans: Overview: Preservation of Capital Requirement (http://us.practicallaw.com/4-525-6649).) Under a market-based cash balance plan, the participant's benefit must be at least equal to the sum of his pay credits. A similar concept for defined contribution plans is an investment option that guarantees that the account balance would, when paid out, at least equal total contributions. This is a cumulative, not an annual, guarantee and is triggered at the participant's annuity starting date (generally, any date between termination of employment and normal retirement age, as elected by the participant). 2 Assume in the example above that in year two, the employee earns another pay credit of $2,500. When added to the existing account balance of $2,650, this benefit brings the total account value up to $5,150. Now assume that plan assets lose 4% during the second year. The account balance falls to $4,944 ($5,150 times 0.96). However, the participant's benefit cannot fall below the sum of pay credits, which is $5,000 in this case ($2,500 plus $2,500). The difference, $56 ($5,000 minus $4,944) represents an additional benefit that the employer is responsible for if the participant terminates employment and elects a lump sum benefit. PLAN SPONSOR RISK Practitioners have different views on the significance of the preservation of capital requirement. Some practitioners: Believe it presents significant risk. For example, they argue that a one-time market event can cost the plan sponsor significant money over and above the explicit promise of contributions plus trust earnings. Do not view this risk as prohibitive because the participant must terminate employment for the risk to occur and for a participant with any significant tenure, past earnings generally provide an earnings cushion. FACTORS THAT AFFECT THE PRESERVATION OF CAPITAL RULE The preservation of capital rule presents some risk to plan sponsors. The following factors can affect this risk: Asset allocation. Asset allocation affects both the frequency and the magnitude of risk. The frequency of risk refers to how often the preservation of capital rule applies, while the magnitude of risk is how much the guarantee costs. Stocks generally increase both the frequency risk and magnitude risk, at least over shorter periods of time. A portfolio with more stocks generally increases the cost of complying with the preservation of capital rule. Turnover. Because the preservation of capital rule only comes into play at termination of employment, the guarantee cost depends (in part) on how many participants terminate at any time. If turnover is relatively high, the frequency risk of triggering the guarantee is also higher. Tenure. Because the preservation of capital rule provides a cumulative floor, the longer a participant's tenure, the less likely it is to come into play. In a market-based cash balance plan, longer tenured participants generally have a cushion of prior earnings to offset losses in any one year. Relative amount of principal versus interest. To the extent part of the account balance is due to interest credits, there is a cushion so that future investment losses can flow through to account balances, rather than increasing employer cost. This risk is similar to tenure, but it becomes a separate risk where there is a cash balance plan conversion and participants enter the plan with large opening balances subject to the capital preservation minimum. When these factors are correlated, risk becomes increasingly complicated (see Correlation of Risks).
TRADE-OFF BETWEEN FREQUENCY RISK AND MAGNITUDE RISK The cost of complying with the capital preservation rule is the product of the frequency risk and the magnitude risk (see Factors That Affect the Preservation of Capital Rule). For participants with shorter service, the frequency risk (the probability of negative cumulative returns) is the highest, but the magnitude risk (how much the guarantee costs) is the lowest. As time increases, the frequency risk declines while the magnitude risk increases. The frequency risk for diversified portfolios has been zero for 15 years or longer. CORRELATION OF RISKS The risk situation becomes more complicated because some of the factors affecting the preservation of capital rule are correlated (see Factors That Affect the Preservation of Capital Rule). A market downturn may coincide with widespread layoffs (an increase in turnover), and that event may correlate with: Poor investment performance for a sponsor's plan. A plan sponsor's loss of access to capital or credit. Reduced corporate cash flow. After two major volatile market events in recent history (in 2000 to 2002 and 2008), plan sponsors can be reluctant to think of any risk as manageable that is dependent on these factors as asset allocation, layoffs and plan investment performance, but analysis shows that even in these environments, the cost of the capital preservation minimum is only a fraction of 1% of total payroll (see Preservation of Capital Rule). CUMULATIVE FLOOR SAFE HARBOR Plan sponsors also can provide additional protections to participants in market-based cash balance plans, in the form of a guaranteed cumulative return of up to 3% per year. As with the capital preservation rule (see Capital Preservation Rule), more generous guarantees pose the greatest risk for short-service participants, who have small benefit amounts. The longer the participant's account remains in the plan, the potential magnitude of losses also increases, but so does the likelihood of plan assets outpacing the 3% cumulative guarantee. Over periods of time of 20 years or more, the risk of providing a 3% guarantee is generally insignificant. DESIGN SOLUTIONS It is possible to design a market-based cash balance plan to essentially eliminate the small risk to the employer from the preservation of capital rule (see Preservation of Capital Rule), although doing so may make the market-based cash balance plan look less like a typical defined contribution plan. Design solutions include: Conservative asset allocation. The risk from the preservation of capital rule can be eliminated by investing trust assets in capital preservation assets like guaranteed investment contracts, short-term Treasuries or cash. By reducing guarantee risk in this way, returns are generally reduced. While this does not affect the plan sponsor, the participants' investment earnings are reduced. Since investments are optimized to reflect plan sponsor concerns about guarantee risks, a typical defined contribution plan asset allocation is not used (in which trust investments can be optimized to reflect participant preferences and time horizon). Three-year vesting. A three-year vesting rule excludes from guarantee protection participants in generally high turnover groups (reducing the frequency of risk). In effect, it also increases the tenure of those who are vested, since after three years participants are likely to have built up an earnings cushion. Averaging in. The plan sponsor could alternatively provide for a low-risk or risk-free asset allocation for participants with shorter tenure, such as creating a separate, more conservative investment pool for short service employees (for example, less than three years), or in the case of a cash balance conversion, adopting a conservative portfolio for a few years after conversion. In a conversion, where some participants may have accounts with large amounts of principal (converted from a traditional defined benefit plan) and no or little earnings, this sort of strategy may be essential to reduce short-term risk. For more information on cash balance plan conversions, see Practice Note, Cash Balance Plans: Conversions of Pre-existing Defined Benefit Plans to Cash Balance Plans (http://us.practicallaw.com/4-525-6649). Lock-up period. Plans that do not permit distributions for a certain period of time (for example, ten or 20 years, or until a specific age such as 55) also may reduce the frequency risk. BENEFITS OF MARKET-BASED CASH BALANCE PLANS Market-based cash balance plans can provide plan sponsors with stable and predictable costs. They can also allow plan sponsors to deliver retirement benefits that can overcome many of the shortcomings of defined contribution plans by: Covering all employees with a predetermined contribution level designed to meet retirement objectives. In defined contribution plans (even plans with default contribution rates) some employees opt out and receive no benefit, or elect to defer insufficient contributions. Sharing investment risks and rewards between employers and employees in a way that traditional defined benefit and defined contribution plans cannot. While such sharing will introduce some volatility into employer costs, the volatility is typically a small fraction of what plan sponsors of traditional defined benefit plans face and may not be much different from the minor cost fluctuations associated with a 401(k) match (where the cost is dependent on employee deferral elections and forfeitures). In a market-based cash balance plan, employers can fine tune risk sharing provisions to suit their own risk tolerances. Aligning employer and employee interests to increase investment returns and reduce the need for fiduciary oversight. In a 401(k) plan, fluctuations in plan asset values have no effect on employer costs. In a a market-based cash balance plan, a plan sponsor might credit a certain amount of trust returns to participant accounts (for example, 90%), providing comfort to participants that investment results have real financial consequences for sponsors. 3
Combining downside guarantees with upside potential, which can be attractive to employees. In defined contribution plans, this is difficult to achieve. Restricting access to funds before retirement and reducing or eliminating the problem of leakage (the possibility of accounts being withdrawn and spent before retirement) that defined contribution plans face. Restrictions on withdrawals can also reduce the cost and risk of any guarantees provided by employers. Providing annuity payment options in market-based cash balance plans is straightforward (such options are required for these plans). Similar features are rare and difficult to implement in defined contribution plans, although this trend may be changing (see Legal Updates, Lifetime Income Guidance on Target-date Funds (TDFs) Issued by IRS and DOL (http://us.practicallaw. com/5-585-8145) and IRS Issues Final Regulations Simplifying Use of Annuities in Retirement Plans (http://us.practicallaw.com/8-573- 0626)). Some of these advantages can be achieved with a managed defined contribution plan but many of them, including risk sharing, guarantees and annuitization cannot be achieved as easily as in a market-based cash balance plan. DRAWBACKS OF MARKET-BASED CASH BALANCE PLANS Market-based cash balance plans may not be suitable for all employers, as market-based plans have additional overhead costs, including actuarial fees and Pension Benefit Guaranty Corporation (PBGC) premiums, which may be a deterrent for some small employers or employers with predominantly low wage employee groups. Some employers may also find market-based cash balance plans less than compelling, including employers: Who have an overriding interest in fixed retirement costs and who see little or no value in sharing risks or providing guarantees. For whom retirement benefits are an unimportant part of the compensation package. Before the release of the final regulations in 2014, there was some legal uncertainty surrounding market-based cash balance plans. However, with the release of the final regulations in 2014, there is little or no legal uncertainty around most of the design features of these plans (see Legal Update, IRS Issues Final Regulations Providing Guidance on Hybrid Retirement Plans and Proposed Regulations Providing Anti-cutback Relief (http://us.practicallaw.com/8-581-7889) and Practice Note, Cash Balance Plans (http://us.practicallaw.com/4-525-6649)). VALUATION Before daily valuation of accounts became common, defined contribution plans only valued account balances periodically (annually, quarterly or monthly). Technological improvements have transformed that business model over the past several decades. Today almost all defined contribution plans provide for daily valuation of accounts, allowing participants to track accounts in real time. Cash balance plans have not followed this convention, largely because account balances are generally credited with a fixed rate of interest, known in advance, for a given year. Some plans change interest crediting rates more frequently, such as quarterly or monthly, but in general account balances are stable and unconnected with plan investment returns. This changes under a market-based cash balance plan. Interest credits are driven by real investment returns, and participants expect to be able to check account balances regularly in response to changing market conditions, just like in a defined contribution plan. Daily valuation is not just an employee experience issue. For plan sponsors, daily valuation eliminates the gap between when benefits are calculated and when they are paid. For example, a payment lag of several weeks routinely produces an asset to liability mismatch in the 5% range for a typical asset mix (for example, 60% stocks and 40% bonds). Plans that credit interest monthly are tempted to adopt an overly conservative asset mix to dampen (but not eliminate) this volatility. However, doing so reduces the expected investment returns produced under the plan compared to a more traditional asset allocation, which translates to lower benefits to employees. With a daily valuation design, the mismatch is eliminated and benefit values continue to move within a month based on asset performance. COMPANIES IMPLEMENTING MARKET-BASED CASH BALANCE DESIGNS Over the past several years, market-based cash balance designs have become a popular retirement plan design choice for large law firms. Many of these early adopters already sponsored cash balance plans prior to 2008, making the transition to a market-based design a comparatively minor change. The reasons for this trend are: Stable and predictable contributions. Access to market returns. Transparent costs. No unfunded liabilities. The existence of generous rank-and-file retirement benefits, which allows for substantial tax-effective deferrals for partners. For similar reasons, these designs can be attractive to other professional service organizations, including: Medical practices. Engineering firms. Investment companies. Other small employers and partnerships. These designs can also be used to replace non-qualified deferred compensation (NQDC) programs. Now that the IRS has released final regulations (see Legal Update, IRS Issues Final Regulations Providing Guidance on Hybrid Retirement Plans and Proposed Regulations Providing Anti-cutback Relief (http://us.practicallaw.com/8-581- 7889)), larger employers could see adoption of market-based provisions for existing cash balance plans, since they can provide stable costs to employers and market returns to participants (see Benefits of Market-Based Cash Balance Plans). 4
Plan sponsors of frozen defined benefit plans also can use marketbased cash balance plans as a bridge to plan termination by converting frozen pension benefits to account balances, which can substantially reduce financial risk and avoid the exit premium that is typically paid on plan termination (see Practice Note, Freezing Defined Benefit Plans (http://us.practicallaw.com/6-502-3611)). Sponsors of defined contribution plans who are concerned with participants' ability to navigate the retirement planning process can alleviate this concern by implementing risk-sharing features available under market-based cash balance plans, including professional investment performance, financial guarantees and straightforward annuitization (see Design Solutions). ABOUT PRACTICAL LAW Practical Law provides legal know-how that gives lawyers a better starting point. Our expert team of attorney editors creates and maintains thousands of up-to-date, practical resources across all major practice areas. We go beyond primary law and traditional legal research to give you the resources needed to practice more efficiently, improve client service and add more value. If you are not currently a subscriber, we invite you to take a trial of our online services at practicallaw.com. For more information or to schedule training, call 888.529.6397 or e-mail training.practicallaw@thomsonreuters.com. 02-15 Use of Practical Law websites and services is subject to the Terms of Use (http://us.practicallaw.com/2-383-6690) and Privacy Policy (http://us.practicallaw.com/8-383-6692). 5