What is a Cash Balance Plan?
Before answering this question, some general background information helps put the discussion in context. A defined contribution (DC) plan, such as a 401(k) profit sharing plan, dictates the contributions that go into the plan each year. Contributions, which are usually discretionary, include employee salary deferrals, employer matching contributions and employer profit sharing contributions. The maximum amount a participant can receive in a DC plan each year is $49,000 for those under age 50 and $54,500 for those age 50 or older. These contributions and the investment returns they generate determine a participant’s ultimate retirement benefit. A defined benefit (DB) plan promises a benefit using a formula that is usually based on compensation and years of service. For example, a DB plan might provide an annual benefit equal to 1% of average compensation for each year of service. If a participant has average compensation of $65,000 over 10 years with the company, the annual benefit is equal to $6,500 ($65,000 x 1% x 10 years of service) for the rest of the participant’s life. Rather than limiting contributions, the IRS limits the maximum annual benefit a DB plan can provide to a participant to $195,000 per year. The contribution is a function of how much is needed to fund the promised benefits. While there are a number of variables, the following table summarizes the tax-deductible contributions to fund maximum benefits for DB participants of different ages:| Age | Contribution |
|---|---|
| 35 | $29,000 |
| 40 | $40,800 |
| 45 | $59,400 |
| 50 | $91,100 |
| 55 | $153,900 |
| 60 | $195,500 |
| 65 | $245,600 |
Contribution Credits
Unlike traditional DB plans that express benefits using a formula that can appear esoteric to the average employee, cash balance plans express benefits using specific contribution crediting rates that could be percentages or flat dollar amounts. For example, the plan might provide for an annual contribution credit equal to $1,000 per participant or 5% of each participant’s compensation. Similar to a new comparability, i.e. cross-tested, profit sharing plan, a cash balance plan may provide different levels of benefit to different employees. A typical design might provide $100,000 per year to owners and 5% of compensation to employees. Keep in mind that the plan’s benefits must satisfy nondiscrimination testing, so what works in one situation will not necessarily work in all situations. The contribution credit is added to a notional or hypothetical account for each participant, and he can look at a benefit statement to see the incremental increase each year similar to a 401(k) statement.Interest Credits
The interest crediting rate is the rate at which the plan guarantees interest on the accumulated contribution credits. The interest is added to each participant’s hypothetical account just like the contribution credits. Sounds simple, right? Believe it or not, there are hundreds of pages of regulations detailing how cash balance plans can and cannot establish interest crediting rates. In a nutshell, these regulations mandate that plans can only use a “market rate of return.” Examples of market rates include the 30-year Treasury rate; the interest rate on long-term, investment-grade bonds; a stock market index such as the S&P 500; or the actual rate of return of the plan’s investments. Selecting a rate for a plan is often an issue of risk tolerance. The higher the crediting rate, the higher the benefit over time; however, since the rate must be guaranteed, a higher rate also means higher risk in the event the actual investments do not achieve the guarantee. One common question is whether losses can be credited if the market rate the plan uses is negative. The answer is “it depends.” A plan can credit investment losses to hypothetical accounts, subject to the “preservation of capital rule.” This rule provides that crediting losses cannot reduce a participant’s hypothetical account to an amount less than the sum of all contribution credits. Example: Russell is a participant in a cash balance plan that provides annual contribution credits equal to 5% of compensation and interest credits equal to the S&P 500 annual return.| 2007 | 2008 | |
|---|---|---|
| Russell’s Compensation | $55,000 | $60,000 |
| S&P 500 Annual Return | 5.49% | -37.00% |
| 2007 | 2008 | |
|---|---|---|
| Beginning Balance | $0 | $2,900 |
| Contribution Credit | 2,750 | 3,000 |
| Interest Credit | 150 | -150 |
| Ending Balance | $2,900 | $5,750 |
Vesting and Payment of Benefits
PPA requires that cash balance plans provide full vesting after completion of no more than three years of service, so the six-year graded schedule that is common in 401(k) profit sharing plans cannot be utilized. Since cash balance plans are DB plans, they are required to offer joint and survivor annuities as the default form of benefit payment; however, they can also allow participants to take lump sum distributions.
Whereas traditional DB plans require a number of complex calculations to determine the lump sum equivalent of an annuity, a participant’s hypothetical account balance in a cash balance plan is deemed to be the lump sum amount. Cash balance plans are also permitted to offer in-service distributions when a participant reaches age 62 or older.
Funding
The plan’s actuary calculates the required funding based on a number of factors including the amount of the promised benefits that have accumulated for all participants, each participant’s proximity to retirement age and participant life expectancy.
Let’s go back to our friend Russell and assume he is 30 years old at the end of 2008. The actuary must calculate what Russell’s $5,750 hypothetical account will be worth 35 years later when he reaches the plan’s retirement age of 65. Let’s assume that projected value is $28,000. The actuary must then determine how much the employer must contribute now in order to ensure there is $28,000 available to cover Russell’s future benefit. This process is repeated to arrive at an aggregate funding requirement for the plan based on all the variables for all plan participants.
The funding level the actuary calculates is compared to the actual assets in the plan to determine how much more the employer must contribute to keep the plan fully funded. The higher the plan’s funding level, the lower the required contribution; and the lower the plan’s funding level, the higher the required contribution. Thus, the required contribution for any given year is not necessarily equal to the sum of the contribution credits and the interest credits for that year, and the amount contributed is not earmarked to fund benefits for any specific participant. Rather, it is applied to increase the funded status of the entire plan.
In order to provide added security to the retirement benefits promised by these plans, the PPA established more strict funding requirements. Plans for which the ratio of actual to required funding falls below 80% are prohibited from increasing plan benefits, and the plan’s ability to pay lump sum distributions to departing participants is restricted. Plans with a funding ratio below 60% must freeze future benefits and the ability to make lump sum payments is eliminated.
While it might seem obvious that an underfunded plan should freeze future benefits, employers can find themselves in an unenviable position when they must tell former employees seeking benefit distributions that they cannot receive their full benefit due to a funding problem.
Investment Accounts
While most DC plans allow participants to direct the investment of their own accounts, all of the assets in a cash balance plan are generally maintained in a pooled account and invested by the plan trustee(s) or a professional investment manager. Since the plan sponsor must guarantee benefits regardless of the actual return on investment, a disciplined investment strategy is necessary. Some will seek to exactly mirror the plan’s interest crediting rate so that the plan’s investments are generating the exact amount of income needed. Others will seek to generate slightly higher returns to improve the plan’s funding ratio and reduce the amount the employer must contribute.
It is suggested that the plan sponsor work together with the actuary and investment manager to determine the most appropriate strategy given the plan design and the sponsor’s risk tolerance and cash flow.
Other Considerations
There are several additional points worth noting. First is that like other qualified retirement plans, the assets held in a cash balance plan are protected from the plan sponsor’s creditors and legal judgments. This may be particularly advantageous for business owners in higher-risk occupations.
Second, all types of defined benefit plans are generally required to purchase coverage from the Pension Benefit Guaranty Corporation (PBGC). The PBGC insures a portion of the plan’s promised benefits in the event the sponsor becomes insolvent and is unable to satisfy its funding obligation. Certain types of employers such as professional organizations, e.g. doctors and attorneys, with fewer than 25 employees are exempt from coverage. While there are a number of factors that impact the cost of PBGC coverage, the flat rate premium is generally $35 per participant.
Is a Cash Balance Plan Right For You?
Cash balance plans are powerful tools that can address a variety of planning needs from tax and retirement planning to estate and business succession planning. One of the most important requirements is consistent cash flow. Since annual contributions are generally required, a business that has irregular cash flow could have trouble meeting its funding obligations during slower years, leading to benefit restrictions and excise taxes. In addition, the annual costs of maintaining the plan are typically paid by the plan sponsor and not from the plan itself since any reductions in plan assets will reduce the funded status and require additional contributions.
To maximize the ability to provide greater benefits to a company’s key employees, cash balance plans are usually used in conjunction with 401(k) profit sharing plans. However, the stability of the demographic make-up of the workforce is an important variable to be considered when designing the benefit formulas.
Companies considering cash balance plans should work with qualified, experienced professionals who can discuss the pros and cons and tailor a plan design to meet their goals.
This newsletter is intended to provide general information on matters of interest in the area of qualified retirement plans and is distributed with the understanding that the publisher and distributor are not rendering legal, tax or other professional advice. Readers should not act or rely on any information in this newsletter without first seeking the advice of an independent tax advisor such as an attorney or CPA.
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Spring will arrive soon, promising new growth and a fresh beginning. It could also be the perfect time to do some spring cleaning for your plan. Let’s look at some areas that you might consider reviewing to ensure your retirement plan is operating efficiently.
Document your processes and procedures to make certain that plan tasks can be handled in case of any absences during an enrollment or pay period. Having a backup in place can prevent errors and delays that could lead to penalties.
Make sure to have a process in place to notify all new enrollments of their eligibility, regardless of whether the plan has automatic enrollment. Depending on the timing for plan entry, including the plan enrollment paperwork with the new hire paperwork could make entry easier for you. Please reach out with any questions regarding when an employee enters the plan.
Deposits of employee deferrals and loan repayments must be submitted to the plan as soon as possible to avoid penalties and corrections. For plans with less than 100 participants, a safe harbor rule allows deposits to be made within seven business days. For larger plans, the expectation is that the money will be deposited more quickly. Depositing these funds on the pay date will avoid the possibility of being late.
Monitoring deferral contribution limits during the calendar year will avoid refunds after year end. Make sure that your payroll is set up to stop deferrals once the limit is reached, including any catch-up contributions for those who have reached age 50.
To keep the plan in compliance, employer contributions must be deposited timely. Due dates are impacted by the type of contributions, required status and tax deductibility. If you have questions on when to deposit your employer contribution or even whether to make an employer contribution, please contact us.
Most plans must be covered by a fidelity bond. The minimum coverage is 10% of plan assets (rounded up to the next $1,000) and the maximum coverage is $500,000. Additional requirements apply to plans with employer securities or non-publicly traded assets. If your fidelity bond is insufficient, now is the time to raise the coverage. Inflation clauses that increase the bond amount as the plan assets increase can ensure that your bond coverage is always adequate. Contact us or your insurance provider if you don’t have a fidelity bond.
Another area to review is communication with participants. Helping your employees understand and trust the plan can increase their contributions. Be sure that your procedures include distributing any plan-related communications—including required participant notices.
Distributions also involve communication, including some of the aforementioned notices. Discussing distribution options with terminated participants, possibly as part of an exit interview, can help to reduce risk of lost participants. We’ll provide instruction on distributions for force-out distributions for small balances, testing corrections and required minimum distributions.
Your plan document is the legal source on how the plan should be administered; operating within its parameters is critical. It’s always worth taking time to review the plan document to ensure that you fully understand and are following its provisions. We’ll cover more details about the plan document later in this newsletter. We’re here to support you in keeping your plan in compliance. Please feel free to reach out with any questions.
Addressing the Challenge of Uncashed Distribution Checks
Uncashed distribution checks present a persistent and often overlooked challenge for retirement plan sponsors. Despite the best efforts of plan administrators, some participants fail to cash their distribution checks, leading to administrative burdens, fiduciary concerns and potential compliance issues. A recent publication by Retirement Management Services (RMS) sheds light on this issue and offers practical guidance for employers seeking to manage and mitigate the risks associated with uncashed checks.
Uncashed checks can arise for various reasons. Participants may have moved without updating their contact information, may not recognize the check as legitimate or may simply forget to deposit it. Regardless of the cause, the responsibility for addressing these uncashed funds ultimately falls on the plan sponsor. This creates a fiduciary obligation to act in the best interest of the participant while ensuring compliance with IRS and Department of Labor (DOL) regulations.
Sponsors are encouraged to maintain up-to-date contact information for all plan participants and to follow up promptly when checks remain uncashed. This may involve sending reminder letters, making phone calls or using certified mail to confirm receipt. In some cases, plan sponsors may also consider using electronic payment methods to reduce the likelihood of checks going uncashed in the first place.
The IRS and DOL have issued guidance on how to handle these situations, including the use of forfeiture accounts and escheatment to state unclaimed property programs. However, these options come with their own set of rules and potential pitfalls. For example, using a forfeiture account may require the plan document to explicitly allow for such treatment. Escheatment laws, which allow the government to assume control of unclaimed property, vary by state. As such, plan sponsors must carefully evaluate their options and consult with legal or compliance experts as needed.
Another important consideration is the documentation of all the efforts made to contact participants and resolve uncashed checks. Maintaining a clear audit trail can help demonstrate fiduciary prudence and protect the plan sponsor in the event of an audit or legal challenge. It is extremely important to have a written policy in place that outlines the steps to be taken when a check remains uncashed beyond a certain period.
By taking a proactive, well-documented and compliant approach, employers can fulfill their fiduciary duties, reduce administrative burdens and ensure that participants receive the benefits they are entitled to.
Source: Retirement Management Services – “Uncashed Distribution Checks” https://www.consultrms.com/Resources/59/Plan-Sponsor-Tips-and-Help/212/Uncashed-Distribution-Checks
Divorce and the Retirement Plan
When a participant in a qualified retirement plan undergoes a divorce, the participant’s account balance may be an asset that is split with the former spouse. As the plan exists for the exclusive benefit of its participants, a court order is required to transfer the participant’s benefits to the ex-spouse. Once approved by the plan administrator, this court order is called a Qualified Domestic Relations Order (QDRO).
The QDRO is a judgment, decree or order that must be issued by a state authority (usually a court). It can be part of the divorce settlement or it may be a separate document. Because of the serious nature of separating the participant’s account balance, the QDRO is more than just an agreement made by both parties — it must also be signed by a judge.
A QDRO will describe how to divide the participant’s account balance between the participant and the ex-spouse, referred to as the alternate payee. In some cases, a set dollar amount will be allocated; in others, a percentage of the account may be designated. In the latter case, the amount assigned to the alternate payee represents the given percentage of the participant’s total vested account balance as of a specified valuation date. This percentage will apply to all sources — such as deferrals, matching or profit sharing — unless specified by the QDRO. Any interest and investment gains/losses that accrue between this valuation date and the date the funds are separated into an account for the alternate payee are often factored into this final calculation. If the participant has outstanding loans, the QDRO will usually indicate how the loans are handled.
Contributions such as deferrals and employer matching made after the valuation date are credited to the participant’s account. Earnings and losses are applied to the account balances. Once the division is complete, the alternate payee’s portion (either dollars or shares) is transferred to an account in the alternate payee’s name.
If the plan allows, the alternate payee may be paid out in a cash or rollover distribution. Not all plan documents allow the alternate payee to receive a distribution before reaching normal retirement age, so it’s important to follow the terms of the plan. In addition, the QDRO cannot violate the provisions of the plan document by requiring a plan to provide an alternate payee or participant with any type or form of benefit not otherwise provided under the plan.
Although the most common situation for a QDRO is a divorce, it can be issued in other situations, such as to a dependent in the case of child support. If the alternate payee is a minor child or legally incompetent, the order can also require payment to the individual with legal responsibility for the alternate payee. If a participant or their attorney provides you with a copy of a divorce decree that references the plan or a QDRO, please contact us immediately, and we will work with you to ensure it meets the requirements of the plan.
Important note for defined benefit plans: For 2025 plan years, PBGC premiums are due one month earlier than usual, specifically on the 15th day of the ninth month after the beginning of the plan year. For calendar year plans, this means the premium is due on September 15, 2025, instead of the usual October 15. This accelerated deadline is due to a provision in the Bipartisan Budget Act of 2015.
Upcoming Compliance Deadlines for Calendar-Year Plans
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