So, you are planning on setting up a cash balance plan. You have heard about how complex the plans can be. But how much do you know about the cash balance plan interest crediting rate?
There are many components to the calculation. Some of them are easier to understand than others.
In this article, we will dig into the details of the interest crediting rate. We will discuss the difference between using fixed, variable or actual (market) based rates. Let’s jump in.
Table of contents
What is an interest crediting rate or ICR?
Cash balance plans are qualified retirement plans that allow eligible employees to receive tax-deferred retirement benefits that far exceed those of a 401k plan. Cash balance plans are often called “hybrid” plans because they have similar characteristics of both a traditional defined benefit plan and a defined contribution plan.
A cash balance plan provides benefits to a participant using a different mechanism than the traditional defined benefit plan. The interest credit must be given at least annually.
Some plans credit interest more frequently, such as monthly, quarterly or semi-annually. The plan document will describe how to carry out the calculation including the interest rate to be used and how it is applied to the account balance.
The plan document has an interest crediting rate written into the plan. The employee participant accounts will grow each year based on the pay credit and the interest credit.
The ACR can be a handful of different rate options. But it can also be the actual rate of return or market rate of return.
Cash Balance Plan Interest Crediting Rate
In some cases, a minimum interest rate may be defined. For example, the interest rate could be defined to be the rate published for 30-year Treasury securities, but not less than 4%. A definition of this type is often necessary to help the plan satisfy the minimum accrual rules of IRC §411(b). A maximum interest rate may also be used.
These plans can offer more significant retirement benefits in a tax-sheltered vehicle. More companies should consider a market-based cash balance plan.
As a result of IRS changes, companies can now set the ICR to equal the Market Rate of Return or the Actual Rate of Return. This is also sometimes referred to as the yield on plan assets.
The actual return is rather than striving each year to ensure that investments achieve a targeted interest rate. This structure can reduce investment risk and allow for more predictability in annual contribution amounts.
Fixed & Variable Interest Crediting Rate Options
Below is a list of valid interest credit options.
- The discount rate on 3-month Treasury Bills
- The discount rate on 6-month Treasury Bills or 12-month Treasury Bills
- The yield on 1-year Treasury Constant Maturities
- The yield on 2-year or 3-year Treasury Constant Maturities
- The yield on 5-year or 7-year Treasury Constant Maturities
- The yield on 10-year or any longer period Treasury Constant Maturities
- Annual rate of change of the Consumer Price Index
- First or second segment funding interest rate
- Any of the three lump-sum segment rates
- Actual asset rate of return (only allowed in certain cases)
IRS rules require the interest crediting rate be no more than a market rate (it is not clear exactly what a market rate is). Generally, you apply the interest rate to the beginning of year account balance. The higher the rate the more generous the benefit is. The employer pays this in the form of higher contribution amounts.
Usually, the rate is set once a year in advance of (or at) the beginning of the year. It is possible for the interest credit rate to be negative in a particular year.
In that case, it is required that the participant receive at least the sum of the pay credits made to their accounts since they started participating in the cash balance plan. This means that each participant has a floor below which their account balance cannot fall.
As a result, plans tend to impose a minimum interest rate credit to avoid having to compare the current account balance against the sum of the pay credits each year (or whenever a participant is entitled to a distribution).
Market or Actual Interest Crediting Rate
In traditional cash balance plans, the interest credit rate is usually a fixed interest rate, a variable rate, or even a combination of the two. But market-based plans use an interest credit based on actual market performance.
In a low-interest-rate environment, companies with cash balance plans are under pressure – particularly those with fixed interest crediting rates or “greater-of” rates MBCB designs help address other types of risk beyond low-interest rates. It’s challenging to meet the guaranteed rate without taking on additional investment risk. This is contrary to how the pension world moves – trying to reduce risk, not increase it.
Market-based plans don’t have the pressure to hit a specific rate each year. However, the plan will still guarantees that the total return on the fund is a minimum of 0% at the final payout. But that is not an annual requirement. The company can put a maximum annual return cap in the market-based design to allow it to build up excess assets to cover if it applies.
Even if a traditional cash balance plan structure doesn’t impute a minimum fixed rate, this can be challenging to manage the risk.
But if your plan credits are based on the 10-Year Treasury rate, how can you hedge the risk based on this rate? You actually can’t. The 10-Year Treasury Rate is not really an investible instrument.
You could purchase a 10-Year Treasury note, but you would be locking in the 10-Year rate at purchase. But your plan’s rate would fluctuate up and down based on the market for 10-Year Treasuries.
Your interest crediting risk is significantly reduced by using a crediting rate tied to investment performance. The motivation to hit a home run is also reduced because you have no clear payoff as the company sponsor.
The following table spells out the benefits of the different type of rate options:
|Fixed or Variable 🔶||Market or Actual 🔶|
|Variety of IRS Approved Options||Minimizes Overfunding & Underfunding|
|Known Target Rate||Allows Annual Return Cap|
|Industry Standard||Lower Risk Profile|
|Pushes Contributions Higher||Unique Plan Design|
How to Select the Best Rate
The following is a 5 step approach to the selection process:
- Determine risk profile
The fixed or variable rate will guarantee an interest allocation for employees. But an actual rate plan is not pressured to meet a given rate each year. The plan can still ensure that the total plan return will not less than 0% over the plan life. You can also cap the maximum return with a “market” design.
- Examine employee mix
Many employees will like the fact that they receive a guaranteed return. However, if you are solo business owner, that guarantee won’t really matter to you. A company need to review their situation and determine what is best for their employee mix.
- Run a rate illustration
Don’t just look at this year standalone. Run a five year illustration to see the impact over a longer period. You can also build in a sensitivity analysis to determine the impact under various market conditions. Consider long-term inflation and changes in interest rates to support your analysis.
- Select from rate options
The interest crediting risk is greatly reduced by designing a plan where the rate is tied specific to investment performance. You don’t have to hit a home run as long as you don’t go negative on a cumulative basis. You also need to consider the time frame. Do you want to apply the rate annually or would you do monthly or quarterly.
- Communicate results
Your decision will impact future funding levels and also will result in employee questions. So make sure you can communicate your decision to the employees as well as your CPA and financial advisor. Traditional plan structures can be easier to explain and can still give employees a guaranteed return.
In summary, you have plenty of options when it comes to the cash balance plan interest crediting rate. Make sure that you discuss the issue with your administrator in order to get a rate that will work well in your situation.