The Pension Protection Act of 2006 (PPA) changed many of the rules affecting defined benefit and cash balance plans. Recent regulations have helped to make such plans more stable, and consequently more attractive to plan sponsors. New design opportunities now exist for these plans, individually and in combination with defined contribution plans. What follows is an overview of the new provisions along with some plan design illustrations.
Types of Retirement Plans
There are two basic types of qualified retirement plans: defined benefit and defined contribution. A defined benefit (DB) plan promises a specified benefit at retirement for each participant, usually in the form of a monthly annuity payable for the life of the participant (or the joint lives of the participant and a designated beneficiary). This benefit is often based on a participant’s compensation and/or years of service. An actuary determines the amount that must be contributed each year in order to ensure that the funds are available at retirement age. DB plans are often funded entirely by employers, who bear the risk for investment gains or losses.
Most DB plans are subject to insurance premiums of the Pension Benefit Guaranty Corporation (PBGC), a government agency that insures plan benefits. Plans that only cover owners or are sponsored by professional service companies with fewer than 25 employees are exempt from PBGC coverage.
In a defined contribution (DC) plan, benefits are provided from account balances that are funded by employer contributions, employee contributions (such as salary deferrals) or a combination of the two. These contributions along with actual investment earnings comprise the benefits at retirement.
Cash Balance Plan
A cash balance plan is a hybrid—a DB plan that in some ways resembles a DC plan. Each participant receives an annual contribution credit (usually a percentage of pay) and an interest credit based on a guaranteed rate that may change from year to year. The participant’s “account balance” is the sum of all contribution and interest credits. These plans are also subject to PBGC coverage with the exceptions noted above.
As in a traditional DB plan, the employer in a cash balance plan bears the investment risk. An actuary determines the contribution to be made to the plan, which is the sum of the contribution credits for all participants plus the amortization of the difference between the guaranteed interest credits and the actual investment earnings (or losses). Participants appreciate this design because they can see their “accounts” grow but are still protected against fluctuations in the market.
In order to determine contribution and benefit limitations, the actuary converts the guaranteed interest and contribution credits to a monthly benefit at retirement age. Such benefit may not exceed 100% of pay or a specified dollar amount which is adjusted for inflation ($15,000/month as of 2007 for retirement age 62 or later). Contributions in a cash balance plan can be significantly higher for an older employee than the DC contribution limit ($50,000 as of 2007, including catch-up contributions).
Testing for Nondiscrimination
All plans must meet certain stringent guidelines or pass nondiscrimination tests. These rules are designed to ensure that plan benefits or contributions do not discriminate in favor of “highly compensated employees” (HCEs), generally defined as those who own more than 5% of the employer or earned more than a specified amount in the prior year ($100,000 in 2007). All others are considered “non-highly compensated employees” (NHCEs).
When performing nondiscrimination testing, either the benefit at retirement or the annual contribution is compared between HCEs and NHCEs. The type of testing selected need not coincide with the type of plan that is adopted. That is, a DB plan can be tested on a contribution basis and a DC plan can be tested on a projected benefits basis. Testing in this manner is referred to as “cross-testing.”
DB Problems Prior to PPA
DB plans have fallen out of favor over the past several years. Legislative changes forced these plans to value lump sum payouts to terminated participants as much as two to three times higher than the amount accumulated for them under the plan, which led to funding deficiencies. Also, deduction limits did not allow employers to make extra contributions while the economy was strong. When the economy weakened, market losses increased underfunding and many sponsors were faced with rising costs at a time when corporate profits were lower than usual.
Cash balance plans were also affected by the lump sum payout rules. Once again, participants would receive far in excess of their “account balance,” and the plan sponsor would have to amortize the difference. In addition, cash balance plans were plagued with legal problems as some courts found conversions from traditional DB plans to be age discriminatory.
DB Plans After PPA
Under PPA, the funding and lump sum payout rules are being brought into balance. Plan sponsors now have the option of making additional deductible contributions to fully fund the plan and even pre-fund future accruals. In addition, over a period of four years, new rules for lump sum payments will be phased in, resulting in lump sum distributions that are closer to the amount of benefits funded.
Cash balance plans are also provided relief, as long as they follow certain rules regarding interest rates. Lump sum distributions to participants will now equal their “account balances,” without adjustment for various other published interest rates. In addition, PPA clarifies that cash balance plans that follow the new rules are not age discriminatory.
These changes significantly improve the outlook for DB plans by making them more practical and predictable in both costs and benefits. Employers can now take advantage of the unique design alternatives available to these plans. Following are some illustrations.
Cash Balance Plan Example
A cash balance plan can provide partners of different ages the same benefit, as illustrated below. The plan formula is 38.636% of pay for owners and 16% of pay for non-owners.
| Employee | Age | Compensation | Contribution |
| Partner A | 51 | $220,000 | $85,000 |
| Partner B | 58 | $220,000 | $85,000 |
| NHCE | 31 | $25,000 | $4,000 |
The contribution and interest credits are projected to normal retirement age for each participant and then converted into a monthly accrued benefit. The accrued benefits are compared for nondiscrimination testing. As a percentage of pay, the NHCE’s benefit at retirement is greater than that of the two partners (who are HCEs), so the plan is not discriminatory.
Combined Plan Designs
In the past, an employer’s maximum deduction to all plans for a fiscal year equaled the greater of the required contribution for the DB plan or 25% of total participants’ eligible compensation. Under the new rules, as of 2006 an employer can contribute up to 6% of pay to a DC plan in addition to the required DB contribution, even if the resulting total exceeds the 25% limit. Employee deferrals do not count towards the 6% or the 25% limit. This new rule offers many opportunities for a combined plan approach.
DB + Safe Harbor 401(k) Combo
Shown below is a DB plan for 2006 in which the contribution exceeds 25% of payroll. Under the new rules, the employer can also adopt a safe harbor 401(k) plan that meets the 401(k) nondiscrimination requirements by guaranteeing a 3% of pay contribution to all NHCE participants. The plan also allows discretionary profit sharing contributions. In this example the profit sharing contribution is allocated on a cross-tested basis, with a higher percentage going to the owner, who is older. The sum of the safe harbor and profit sharing contributions cannot exceed 6% of total participant compensation.
| Employee | Age | Salary | DB Cost | Deferral | PS Contrib.* |
| Owner | 52 | $220,000 | $133,518 | $20,000 | $14,250 |
| Assistant | 25 | $35,000 | $5,334 | unknown | $1,050 |
| Total | $255,000 | $138,852 | $20,000+ | $15,300 | |
| *Profit sharing contribution includes the 3% safe harbor contribution. | |||||
Prior to 2006, this sponsor would have only been able to deduct the DB contribution, and the owner’s salary deferrals would have been limited based on what the assistant deferred. The addition of the safe harbor 401(k) profit sharing plan allows the owner to increase his own contribution by $34,250 with an additional contribution for the assistant of only $1,050. The assistant can further benefit by making pre-tax salary deferrals into the 401(k) plan.
Cash Balance + Safe Harbor 401(k) Combo
Here is an illustration of a cash balance plan with a safe harbor 401(k) profit sharing plan for 2006:
| Employee | Age | Salary | Cash Balance Cost | Deferral | PS Contrib. |
| Owner 1 | 59 | $220,000 | $100,000 | $20,000 | $14,283 |
| Owner 2 | 54 | $220,000 | $100,000 | $20,000 | $14,283 |
| Other HCE | 56 | $120,000 | $3,000 | $6,600 | $6,672 |
| 8 NHCEs | various | $372,470 | $9,312 | unknown | $20,710 |
| Total | $932,470 | $212,312 | $46,600+ | $55,948 |
Over 85% of the employer contribution is allocable to the owners and they can each defer $20,000 as well. The profit sharing contribution is allocated on a cross-tested basis, with different percentages going to the owners, the non-owner HCE and the NHCEs.
The plan design can go even further by excluding some employees from each plan and combining the plans for testing purposes. It can be useful if you have both older and younger HCEs. The younger HCEs can benefit under the DC plan while the older HCEs benefit under the DB plan.
Note that effective in 2008, DB plans covered by the PBGC will no longer count towards the 25% contribution deduction limit. As a result, sponsors of PBGC insured plans will be able to fund a DC plan up to 25% of compensation in addition to their DB plan.
Other DB Plan Considerations
Employers interested in adopting a DB plan should be willing to commit to the contribution requirements of these plans over the long run. There is little flexibility in calculating required contributions. The plans also tend to be more expensive to administer and, if covered by the PBGC, will incur premium expenses. However, these costs may be far outweighed by the ability to fund significant amounts towards retirement.
The value to a particular employer of any of the plan designs outlined previously is highly dependent upon the ages of the participants. Each of these designs is subject to complicated nondiscrimination requirements which must be performed annually. Changes in the employee census can cause significant changes in the costs and allocations.
Conclusion
PPA has created new plan design opportunities that incorporate DB plans. Traditional DB plans are now less likely to become underfunded with distributions mirroring accumulated contributions with interest. A cash balance plan is a viable alternative to the traditional DB plan, offering a benefit more easily understood by participants. Cash balance plans also allow employers to equalize contributions for key employees of different ages.
Combining traditional DB or cash balance plans with DC plans can greatly expand contribution possibilities. These designs can be highly individualized to best match the census of the plan sponsor. Employers who are interested in increasing their annual contributions and are willing to commit to these contribution levels should seriously consider the alternatives that now exist.
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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