THE CASE FOR CASH BALANCE PENSION PLANS
Amid all the talk in recent years about the demise of pension plans, there is one type of defined benefit plan that is growing very fast. These are Cash Balance plans that have enjoyed a recent resurgence in popularity. When the Pension Protection Act of 2006 (PPA) resolved much of the legal uncertainty of these plans, small and large companies alike showed a renewed interest in setting up cash balance plans, which in actuality have been in existence since 1985.
The PPA formally allowed cash balance plans to fix their interest credit rate to a market index on plan assests instead of treasury bills. With the passage of the SECURE 2.0 Act on December 29, 2022, the plan sponsor can assume an interest credit rate that is a resonable rate of return, provided it does not excede 6%.
Cash Balance plans are sometimes referred to as “hybrid” plans because they combine the high contribution limits of a traditional defined benefit plan with the flexibility and portability of a 401(k) plan. They also avoid the common risk factors and runaway costs involved in traditional defined benefit plans. However, if the market goes down, the employer is still required to make additional contributions to fund the plan, unlike a defined contribution plan like a 401(k) plan.
The past few years have been difficult for all investors as long-held inverse correlations have eroded, and traditional approaches have lost their capacity to produce desired results. One outlet for the sophisticated investor is alternative investments and more specifically, real estate. Many people believe that a “Self Directed IRA” is the only way a retirement plan can invest in real estate. However, the Internal Revenue Code has always permitted investing in alternative assets in qualified retirement plans such as 401(k) plans and defined benefit plans. One significant advantage of investing in real estate in a qualified pension plan is that leveraged or debt-financed property may not be subject to Unrelated Business Income Tax (UBIT) rules to the same extent as IRAs.
Similar to 401(k) plans and traditional defined benefits plans, there are federal pension laws that govern Cash Balance plans. The Employee Retirement Income Security Act (ERISA), the Age Discrimination in Employment Act (ADEA) and the Internal Revenue Code (IRC) all provide certain protections for the employee benefits of participants in private-sector pension plans. These laws set standards for fiduciary responsibility, participation, vesting, benefit accrual and funding. The law also requires plans to give basic information to workers and retirees. The IRC establishes additional tax qualification requirements, including rules aimed at ensuring that proportionate benefits are provided to a sufficiently broad-based employee population.
The Department of Labor (DOL), the Equal Employment Opportunity Commission (EEOC), and the IRS/Department of the Treasury have responsibilities in overseeing and enforcing the provisions of the law. Generally, the DOL focuses on the fiduciary responsibilities, employee rights and reporting and disclosure requirements under the law, while the EEOC concentrates on the portions of the law relating to age discriminatory employment practices. The IRS/Department of the Treasury generally focuses on the standards set by the law for plans to qualify for tax preferences.
According to FuturePlan by Ascensus, formerly Kraviz, Inc., one of the nations leading designers of corporate retirement plans, in the past 15 years, Cash Balance plans have increased from less than 3% to 37% of all defined benefit plans. Traditional defined benefit plans have been steadily declining since the mid- 1980’s, due to a complex array of risk issues, runaway cost, and major changes in workforce demographics. Some larger corporations converted existing defined benefit plans to Cash Balance, while hybrid plans also became increasingly popular with small to mid-size businesses.
A recent publication, entitled National Cash Balance Research Report, was compiled from an in-depth analysis of the latest IRS form 5500 filings for Cash Balance retirement plans. Some of the highlights in their survey include the following:
- Market volatility and economic uncertainty have not slowed Cash Balance growth. The number of cash balance plans nationwide has more than tripled since the Pension Protection Act <PPA> came into effect in 2006.
- Prior to 2020, a new cash balance plan was required to be adopted by the last day of the plan’s initial year. Starting in 2020, the SECURE Act made it so that business owners can adopt a cash balance plan right up to the entity’s tax filing deadline for the plan’s initial year.
- Small and mid-size businesses are the engine for Cash Balance growth. 92% of Cash Balance plans are in place at firms with fewer than 100 employees. Firms with 1 to 9 employees now account for 57% of all Cash Balance plans.
- The 2010 and 2014 IRS Cash Balance regulations allowed for Actual Rate of Return and other investment options, making the plans more flexible and appealing to employers.
- Media coverage of the Boomer generation’s lack of retirement preparedness is prompting older business owners to accelerate savings and maximize qualified plan contributions.
Cash Balance plans provide the following advantages to employees:
- Employees do not have to reduce their take- home pay in order to receive an employer contribution, since the Cash Balance contributions (sometimes also satisfied through a profit sharing plan) are not based on a “match.” Instead, the contribution is made by the employer.
- The Company can base benefits at normal retirement age based on defined benefit calculations and thus can make significantly larger contributions to a defined benefit plan than to a defined contribution plan, which is limited to a maximum of around $66,000 per person per year.
- Employees do not have to choose their own investments or bear any investment risk.
- Partners or owners who need to catch up on delayed retirement savings. Age-weighted contribution limits allow older owners to squeeze 20 years of savings into 10.
- Plan assets are pooled and typically invested by the sponsor using a conservative benchmark, so retirement savings are protected from market volatility.
- Portability: When employees leave or retire, they have a choice of an annuity option or a lump sum that can be rolled over to an IRA.
America’s healthcare, technical, legal and financial sectors continue to lead the way in adopting Cash Balance plans. These plans are an excellent fit for the retirement needs of professional services firms, because of their flexibility for multi-partner firms and high age-weighted contribution limits which allow older owners to double or triple pre-tax retirement savings.
Medical and dental groups account for 37% of all Cash Balance plans nationally and continued growth is expected in the healthcare sector as the economy adjusts to the requirements of the Patient Protection and Affordable Care Act (PPACA). While not yet in the top 10 Cash Balance states, Virginia is closing in rapidly with over 400 plans and annual growth in new plans over 30%.
The basic fundamentals of Cash Balance plans are that the plan specifies both the contribution to be credited to each participant and the investment earnings to be credited on those contributions. Each employee has a “hypothetical account balance” making it easier for employees to understand the plan and allow them to see the benefits over time. The hypothetical benefit amounts are maintained by the plan actuary, who generates annual participant statements. The plan usually provides benefits in the form of a lump-sum distribution or annuity (subject to notarized spousal consent).
Cash Balance plans are subject to the same ERISA requirements as other defined benefit plans, including minimum standards for eligibility, vesting and funding. The benefits in most Cash Balance plans as in most traditional defined benefit plans are protected within certain limitations, by federal insurance provided through the Pension Benefit Guaranty Corporation (PBGC) and must therefore pay PBGC premiums. However, some smaller plans are not subject to PBGC coverage or premiums.
A Cash Balance plan may be less difficult to administer than a defined contribution plan that has loans and hardship distributions. Account recordkeeping is much simpler under a Cash Balance plan because there is no need to reconcile account balances with trust assets, and there are typically no employee contribution, loans, withdrawals, or fund transfers. However actuarial valuation is required and actuarial reports are required each year. Annuities can be paid directly from the trust of a Cash Balance plan and are generally larger than the policies employees could obtain from an insurance company themselves using their account balance.
To illustrate the higher contribution limits for Cash Balance plans, consider that rather than limiting contributions, the IRS limits the maximum annual benefit the plan can provide to a participant to $265,000 per year ($22,083 per month) for life, though a plan can be designed to provide lower benefits. Benefits are only based on compensation capped at $330,000.
The contribution is a function of how much is needed to fund the promised benefits, therefore the Cash Balance plans have generous contribution limits that increase with age. People ranging in age from 50 to 70 can sock away from $188,000 to $398,000 annually in pretax contributions to fund the promised benefit. Compare this to 401(k) total employer and employee contributions for those 50 and older being limited to $73,500 in 2023.
Cash Balance plans and other qualified retirement plans, like 401(k) plans are protected from the plan sponsor’s creditors and legal judgments. This may be particularly advantageous for business owners in high-risk occupations. Secondly, 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 and thus exempt from PBGC premiums. While there are a number of factors that impact the cost of PBGC coverage, the flat rate premium is generally $64 per participant.
Real estate in a tax-qualified retirement plan such as a Cash Balance pension plan can provide diversification for a portfolio. Considerations when maintaining real estate as a plan asset generally include an annual valuation by an independent third-party appraiser and appropriate use of the real estate, such as renting it out at a fair market value. Also, an ERISA fidelity bond must be maintained that covers not less than the appraised value of the real estate. This type of fidelity bond coverage is relatively inexpensive and typically would be in the range of $400 for coverage on $500,000 bond.
Although there are numerous issues to consider, under the right circumstances, real estate is an attractive and appropriate tax-qualified plan investment. Cash Balance plans are “one of the last, best tax breaks left for closely held business owners,” as described by Elmer Rich III, principal of Rich and Co. in Chicago. 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.
When choosing a company to design and administer a Cash Balance plan, there are many choices. One of the largest, FuturePlan by Ascensus, located in offices nationwide, designed their first Cash Balance plan in 1989 and now administers more than 4,000 Cash Balance plans. Other companies that design and administer Cash Balance plans include Pinnacle Plan Design, LLC, headquartered in Tucson, AZ., Northwest Retirement Plans, Inc., located in Medford, OR., and CPH Pension Administrators, Inc., located in Chattanooga, TN. All of these companies have very good websites and offer services not only to large Cash Balance plans with many thousands of participants, but also to small plans with less than ten participants.
Asa L. Shield, Jr., CPA
CCP Commercial Real Estate