3720 / What is a cash balance plan?

A cash balance plan is a defined benefit plan that calculates benefits and contributions in a manner similar to the way that defined contribution plans make those calculations. The similarity ends in that a cash balance plan’s calculations require an actuary. A cash balance plan resembles a defined contribution plan in that each employee has a hypothetical account, or “cash balance,” to which contributions and interest payments are credited. In a typical cash balance plan, the employee’s benefit accrues evenly over the years of service, with annual pay credits to the hypothetical account. There is no separate account. These pay credits usually are a fixed percentage of pay that is stated in the plan document, such as 4 percent.

With no separate account, there is no directed investing available. As with other defined benefit plans, the employer bears both the risk and the benefits of investment performance. That is, losses in the plan’s investments generally require additional employer funding. The actual amount that must be contributed is determined actuarially. This ensures that the plan has sufficient funds to provide the promised benefits.

For plan years beginning in 2012, the interest credit (or the equivalent amount) for any plan year must be at a rate that is not greater than a “market rate” of return. The term “market rate” of return is defined in regulations issued in 2010.¹ A plan will not fail this requirement merely because it provides for a reasonable minimum guaranteed rate of return or for a rate of return equal to the greater of a fixed or variable rate.² An interest credit of less than zero may not result in the account balance being less than the aggregate amount of contributions credited to the account.³ This legislative change eliminates the possibility of “whipsaw,” in which disparate interest rates used for crediting and discounting purposes resulted in the discounted present value of employees’ accounts being higher than the theoretical account’s value.

Planning Point: IRS Revenue Procedure 2018-21 allows certain preapproved defined benefit plans containing a cash benefit formula to use the actual rate of return on plan assets to determine interest crediting. Many expect that this move will encourage more plans to move to the preapproved plan structure, as the IRS has eliminated its determination letter program for many individually designed plans.⁴ The IRS also provided that while the rate used to determine investment credits cannot be based on the rate of return for regulated investment companies (RICs), the actual rate of return can be used even if the plan assets contain RIC returns.

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Planning Point: The Moving Ahead for Progress in the 21st Century Act (MAP-21)⁵ enacted on July 6, 2012, contained interest-rate stabilization provisions for defined benefit plans. In August 2012, the IRS issued Notice 2012-55,⁶ which outlined the MAP-21 segment rates to be used for plan years beginning in 2012.⁷ MAP-21 revises the three segment rates used under the single employer funding rules. The Highway and Transportation Funding Act of 2014 amended the MAP-21 segment rates effective for plan years beginning on or after January 1, 2013;⁸ however, the plan sponsor could elect to defer use of the HAFTA segment rates until the plan year beginning in 2014. Guidance for making the election to defer is found in Notice 2015-42.⁹

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IRS Notice 2012-61¹⁰ provides guidance on pension funding stabilization under MAP-21. The guidance gives flexibility to plan administrators of plans that use the third segment rate by allowing the administrator to interpret the plan terms as requiring either the pre-MAP-21 third segment rate or the MAP-21 third segment rate, as long as the interpretation is applied for interest credited after the first plan year to which MAP-21 is applied for purposes of funding. An amendment to reflect that interpretation will not be considered a plan cutback.

In 2014, the IRS amended Treasury Regulation Section 1.411(b)(5)-1(d)(1)(iii), which provides guidance on the definition of “market rate,” to expand the definition of “market rate” and to clarify that the definition is effective for plan years beginning on or after January 1, 2016.¹¹ Transitional rules were issued in 2015.¹²

In 2017, an IRS internal guidance memo¹³ to its plan examiners provided guidance on whether a cash balance plan meets the definitely determinable benefits requirement when the formula is based upon partial compensation. The memo indicates that the benefits formula will be determinable if the plan terms provide a formula under which the pay credit is arrived at by looking at compensation information otherwise available, even if outside the terms of the plan (e.g., W-2 compensation documentation).