2. Outline
ƒ Brief cash balance overview
ƒ History of interest credit options
ƒ Issues & answers
1
3. Cash Balance Plan Overview
ƒ It’s a DB plan that looks like a DC plan
ƒ Big DB deductions, DC-like simplicity
2
4. Cash Balance Plan Example
DB/DC combo
ƒ Common for professional firms
ƒ Enables large deductible contributions for owners
5. Cash Balance Plan Example
DB/DC combo: cash balance & profit sharing
{ This example is for a PBGC-covered plan, Frankenstein Mfg. Inc.
{ Gateway here is 7½% DC; Igor & Inga get 3% cash balance credits
{ A PBGC-exempt professional firm may need to limit DC er contrs to 6%
Age
2013
Pay
Cash
Balance
Credit
PS &
3% Safe
Harbor
401(k) &
Catchup Total
Dr. F’stein 60 $255,000 $230,000 $33,500 $23,000 $286,500
Igor 40 50,000 1,500 3,750 whatever 5,250+401k
Inga 30 30,000 900 2,250 whatever 3,150+401k
8. History of Interest Credit Options
„ Notice 96-8: Bond indices w/ margins + 417(e) [30-Year T]
Standard Index Associated Margin
The discount rate on 3-month Treasury Bills 175 basis points
The discount rate on 6-month Treasury Bills or 12-month
Treasury Bills
7
150 basis points
The yield on 1-year Treasury Constant Maturities 100 basis points
The yield on 2-year Treasury Constant Maturities or 3-year
50 basis points
Treasury Constant Maturities
The yield on 5-year Treasury Constant Maturities or 7-year
Treasury Constant Maturities
25 basis points
The yield on 10-year Treasury Constant Maturities or any
longer period Treasury Constant Maturities
0 basis points
Annual rate of change of the Consumer Price Index 3 percentage points
„ Notice 07-06: long-term corporate bonds, PPA 3rd segment
rate, 30-Year T, or rates in 96-8
9. PPA – Statutory Hybrid Plan
Definition DB plan where portion of accumulated benefit is:
„ Current hypothetical account balance
(cash balance plan); or
„ Accumulated percentage of final average pay
(PEP plan)
8
What you get „ Whipsaw relief
„ Age-discrimination relief
What you give „ 100% vesting in 3 years (entire benefit)
„ Interest Credit can’t exceed “market rate of return”
10. History of Interest Credit Options
„ 2010 Proposed Regulations
– Rate of return on plan assets, if prudently diversified 404(a)(1)(C)
– Rate of return on regulated investment company
• Mutual funds (e.g., S&P 500 index)
• Should not be more volatile than broad equity market
– Fixed 5.0% (with 411(d)(6) relief if switch from 3rd segment rate)
– “Greater of” rates [floors]
• Max annual 4% floor if IC rate is fixed income safe harbor
• Max cumulative 3% floor if equity-based IC rate
9
„ No final regulations yet
11. History of Interest Credit Options
Interest Credit Floor Example
ƒ Interest Credit = S&P 500 (actual from 2007 – Oct 2010)
ƒ Principal Credit = $10,000 per year
10
12. Interest Credit Example
Preservation of Capital Example
ƒ Interest Credit = S&P 500 (actual from 2007 – Oct 2010)
ƒ Principal Credit = $10,000 per year
11
13. Market-Based CB Plan Issues
1. Investment risk (assets < cash balance accts)
2. §401(a)(4) nondiscrimination testing
3. Top-25 HCE lump sum restrictions
4. Overfunding (account > §415 max lump sum)
5. §401(a)(26) 50-ee/40% “meaningful benefits”
6. DB accrual rules
7. Administration – lump sum & annuity payouts
12
14. Market-Based CB Plan Issues
1. Investment risk (assets < cash balance accts)
Issue Answer
13
“Preservation of Capital” rule:
• Payout can’t be less than sum of
pay credits
• i.e. cumulative return for each
participant can’t be less than 0%
Investment risk can be lower than a
traditional cash balance plan.
Can manage risk, but not escape it.
Possibilities include:
• Conservative investments
• Cap interest credits to capture
investment gains for plan sponsor
• Delay distribution
15. Market-Based CB Plan Issues
2. §401(a)(4) nondiscrimination testing
Issue Answer
14
Successful nondiscrimination test may
depend on “turbo charging”
• DC contributions projected @ 8½%
• CB credits projected at lower rate
• CB credit produces a lower testing
benefit than an equal DC contrib
Market-based plan may project at a
higher rate
• Less turbo-charging advantage
IRS position is that CB testing
should be done at previous year’s
crediting rate.
Can improve passing chances with:
• Conservative investments
• Capped interest credits
16. Market-Based CB Plan Issues
3. Top-25 HCE lump sum restrictions
Issue Answer
15
Funding “whipsaw”
• CB account projected at market rate
• Discounted back at low IRS rates
• Produces liabilities higher than total
cash balance accounts
• If assets < 110% of liability, can’t
pay lump sums to top 25 HCE’s
Current actuarial practice is to
project accounts at expected long-term
return.
Can improve results with:
• Conservative investments
• Capped interest credits
• Extra funding to reach 110%
17. Market-Based CB Plan Issues
4. Overfunding (account > §415 max lump sum)
Issue Answer
16
With strong investment returns,
individual account balance can
exceed §415 maximum lump sum
• Money is trapped in the plan
• Excess subsidizes other
participants’ benefits
Can make it up outside the plan,
or reduce risk with:
• Conservative investments
• Capped interest credits
• Lower pay credits to “leave room”
• Delayed distribution until §415
dollar limit catches up
18. Market-Based CB Plan Issues
5. §401(a)(26) 50-ee/40% “meaningful benefits”
Issue Answer
17
Benefits must be “meaningful” to
count participant as covered in plan
IRS position (de facto safe harbor) is
a pay credit generating a ½%-of-pay
benefit at normal retirement age
• Projections after a bad investment
year produces low benefits
• Might not be enough people at ½%
to meet the 50-ee / 40% test
Can reduce risk with:
• Conservative investments
• A floor (e.g. 0-3% cumulative) on
interest credits
19. Market-Based CB Plan Issues
18
6. DB accrual rules
Issue Answer
Need to satisfy DB accrual rules
• Designed to prevent
“backloading” of benefit accruals
to get around a vesting schedule
• 3 alternative rules, most cash bal
plans rely on 133-1/3% rule
• No future benefit accrual can be
> 133-1/3% of earlier accrual
• Projections at low return rates
produce low early accruals
Can reduce risk with:
• Reduced age or service grading of
cash balance credits
• Conservative investments
• A floor (e.g. 0-3% cumulative) on
interest credits
20. Market-Based CB Plan Issues
7. Administration – lump sum & annuity payouts
Issue Answer
19
Pure market-based account balance
is unknowable beyond today
• Need to provide survivor annuity
options in addition to lump sum
payout
• Participant needs 30 days for
annuity election
Can make balance knowable by:
• Crediting actual return through
termination with payout reasonably
soon thereafter, or
• Making all payouts after year end
21. Contact Information
20
Mark Schulte, FSA, EA, MAAA
marks@vaniwaarden.com
612.596.5971
Jim van Iwaarden, FSA, EA, MAAA
jimvi@vaniwaarden.com
612.596.5961
Van Iwaarden Associates
840 Lumber Exchange
10 South Fifth Street
Minneapolis, MN 55402
www.vaniwaarden.com
1.888.596.5960
