Cash Balance Plan Investment Strategy: Best Options [Video]


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You’re all set. You set up your cash balance plan and you are ready to fund it. But what is your cash balance plan investment strategy and what investment options do you have?

In this post, I will give you some guidance on investment strategy and warn you of a few pitfalls. I am not a financial advisor, but at least I can point you in the right direction.

Cash Balance Plan Investment Strategy

Interest Crediting Rate Options

You may have heard that there are risks if your plan investment returns are over or under the investment return stated in your plan document. But you don’t exactly know about how this works.

Selecting a fixed interest crediting rate (“ICR”) makes the most sense for most businesses. These standard rates are called safe harbor rates. 

The rates are simple to communicate to employees and are a constant, known amount. The typical goal is to mirror this rate. Options include:

  • Fixed interest rates. The IRS allows companies to choose a fixed ICR of up to 6%.
  • 30-year Treasury rate. The IRS will enable accounts to receive a credit equal to the 30-year U.S. Treasury bond yield, which in recent years has averaged 2% to 4%.
  • Combo rate structure. You may use a “floor” of up to 5% with any safe harbor rate. As an example, the company could choose an ICR that equals the greater of 4% or the 30-year Treasury rate.

Actual or Market Rate Options

The plan document can allow the ICR to be the actual rate of return on the invested plan assets. But some restrictions must be considered. For example:

  • Volatility must be limited. Investments must be diversified, and employer stock is restricted to 10% or less.
  • There is a rule called preservation of capital. It ensures that the employee payout is not less than the sum of the employer plan contributions.

This option is not that popular for small plans. However, it can make sense for large companies and professional service businesses with many partners.

Fixed RateMarket or Actual Rate
Usually 4% to 5%Most common approach
Best for testing with employeesBest for solo plan or professional group
Eliminates any variabilityMust establish a floor (preservation of capital)
Easy for employeesAllowed to cap upside

Investment Basics

A wide range of investments is allowed in cash balance plans. These include the following:

  • stocks
  • bonds
  • cash
  • mutual funds
  • exchange traded funds

The above assets are considered qualified assets. That’s because they trade on regulated exchanges and are liquid.

But more exotic investments are also allowed. Questionable investments could include:

  • paintings
  • coin collections
  • collectibles
  • baseball cards
  • bitcoin
  • real estate
  • commodities
  • derivatives

These investments are considered non-qualified assets. This is because they do not have a well-established market value and do not trade on regulated exchanges. As such, these investments may not meet the owner’s requirement to act in the sole and best interest of the participants for their benefit.

The business owner can manage the investments directly or delegate the investment management to a third party. If the company has employees other than the owner, it can be challenging for the owner to prove they acted prudently in selecting a risky investment class.

In addition, there may be additional requirements for non-qualified assets. This includes an appraisal by an independent third party. This will increase the cost and complexity of the administration of a plan with these investments.

Cash Balance Plan Investment Options

How should you invest cash balance plan assets? 

First of all, we are not financial advisors, and we cannot give financial advice. But we can say that these funds should be invested more conservatively than other retirement accounts.

Small business owners often look to maintain consistent annual contributions to lower taxable income. These companies enjoy predictable long-term annual funding. The goal is usually to have a mix of stocks and bonds.

We know our clients have varying goals. Most want to lower taxable income with annual plan contributions. Other business owners are less concerned with lowering taxable income. They simply want to accumulate considerable retirement savings. 

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Companies looking to fund at a consistently significant level and who want predictable annual contributions should invest their assets conservatively. The goal would be to essentially match the interest crediting rate. This lowers yearly volatility. 

Most actively managed fixed income portfolios and conservative stock/bond investments are appropriate to meet this objective. When the annual return is less volatile, the actuary can typically keep annual contributions relatively consistent from year to year. This will allow the funding to come close to matching the company’s accrued benefit.

Active investment management allows flexibility to adjust between multiple equity sectors, fixed debt instruments (including government, corporate, below invest grade, etc.), and laddering maturities based on the market environment.

Laddered Bond Approach

Most advisors recommend U.S. Treasury notes and bonds as a more conservative and less volatile investment than stocks. However, once the actuary performs the annual valuation and calculates a funding range, bond portfolios are marked to market. This means the valuation is based on the fair market value on the valuation date.

For example, if the valuation date is December 31st, bond investments are valued as if they were sold on that date regardless of the interest rate and maturity.

Taxes written on hanging tags

Should interest rates rise, then the bond value will decrease. The portfolio’s asset values could be significantly impaired if rates rise substantially. Conversely, lower interest rates can result in considerably higher bond valuations limiting employer contributions for the given year.

Large companies can typically tolerate these swings in funding requirements. But such volatility is undesirable for smaller businesses.

Bond Mutual Funds

A bond index such as the U.S. Intermediate Government Treasuries is another approach used to control volatility and help support the funding goals. As such, companies could invest plan assets in all fixed-income mutual or exchange-traded funds (ETFs). 

However, risks still exist as investor sentiment, and interest rate changes will impact the fund’s share value. In addition, if interest rates reside at low levels, prior results might not be achievable in the future. It might make sense to take an active approach to managing the funds.

Stock and Bond Portfolios

A portfolio mix of stock and bond investments is a common investment approach with cash balance plans. These investment portfolios often have a stock allocation ranging from 25% to 70%. 

Many allocations are completed based on a historical analysis demonstrating stocks outperforming bonds over most long-term periods. An investment approach with 35% allocated to stocks will typically enable the company’s long-term funding goals. 

Over the years, there have been wide ranges of returns. However, contribution goals are typically not under pressure as long as a diversified portfolio is maintained. 

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If a portfolio is structured correctly, we have seen an analysis that shows annualized returns between -5% and 15% in around 85% of annual periods. In addition, we have seen between 3% and 7% in about 65% to 70% 10-year time frames.

The majority of calendar returns would be limited compared to these extremes. But a conservative and diverse portfolio is a great starting point for many cash balance plans.

A reasonably standard asset allocation for a defined benefit plan is 60% stocks and 40% bonds. Ultimately the trustee will want an asset mix that closely aligns with expected future benefit payments.

Fixed Income Investing Strategy

Many investors put all cash balance plan investments in bonds or fixed-income investments. A bond’s value may be negatively affected by inflation, while the interest rate risk reflects the potential for the principal to fall below par.

Bonds are not inflation-proof, and the risk of default can occur when the issuer doesn’t pay the principal when due. A bond’s interest rate can also be affected by inflation, which can eat into the original investment’s buying power.

A common advice for investors is to invest in equities while still young, but to shift to a more stable investment strategy as you age. While it’s true that equities have their place, fixed income is often a better fit later in life.

Cash Balance Plan Investment Options

In addition, investors may want to consider high-quality short-term bonds if they want to protect their capital and receive a more predictable income stream. As long as investors know their objectives, fixed income investing may be the best choice for them.

While bonds offer the potential for a high return, they also carry risk. The issuer’s creditworthiness and the bond’s duration are key factors in determining the level of risk. Bonds that mature in more than 10 years are considered the safest options, but they also carry the most risk.

Interest rate hikes, which can lower the value of an investment, are particularly risky for long-term bonds. Furthermore, a long-term bond has a longer repayment time, allowing it to default on payments at a lower rate.

StocksBonds
Potentially higher returns and riskMore conservative
Can lead to volatile contributionsPays a fixed income
Allocated in ETF or mutual fundsSubject to issuer creditworthiness
Can result in over or underfundingNot risk-free (subject to default)

What about overfunding or underfunding?

Under a defined benefit plan, assuming all other factors are the same, if the assets produce better than expected returns, the plan sponsor’s contribution will decrease because the earnings on investments will cover more plan liabilities.

If the assets produce less than due returns, the plan sponsor’s contribution will increase because they must make up for the investment loss to cover plan liabilities. A common objective is to have an asset mix covering liabilities, providing a consistent return, and limiting risk in increased contributions to the plan sponsor.

Any investment returns below the plan’s interest crediting rate will tend to increase future contributions. Many companies want plan contributions to lower taxable income and to prevent the plan from being too over or under-funded. As equity exposure increases, so will investment volatility and risk.

What am I allowed to invest the money in?

The good news is that cash balance plans allow you to invest in almost anything. Most plans will be invested in mutual funds, stocks, bonds and CDs. This is just like a 401(k) plan. Employees do not have the ability to “self-direct” assets as all the funds are held in a pooled account.

Most people simply set up an account with their financial advisor or with an online broker like Vanguard, Charles Schwab or Fidelity. You simply open up a pension trust account or retirement trust. It isn’t really a “special” account because it is what you would do essentially to open up a 401k.

Is there a specific cash balance plan investment strategy?

So what type of strategy should you employ with your cash balance plan investments?

Plans are set up with an interest rate credit. So in theory the business owner should attempt to match this amount. But this can be tougher than you might think.

Even though you want nice investment returns, you want to limit volatility. If volatility is low it will not have much impact on your annual contributions.

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But be careful with highly volatile investments (Bitcoin is one that comes to mind). If a plan invests in speculative stocks and there is a large decline, this will generally result in larger funding contributions in future years. Essentially, you have to “catch-up” your contributions for the lower returns.

Qualified AssetsNon-Qualified Assets
Dividend & Blue-Chip StocksPrivate Loans & Notes
Certificates of DepositBitcoin & Crypto
Conservative Index FundsReal Estate
Bond Funds & ETFsNASDAQ Stocks

However, the contrary can occur. If the plan has large investment returns, the result can be lower contributions in future years. We all want to have high investment returns, but lower funding levels is not necessarily great for a high earner who is looking to maximize tax deductions.

Can you invest in real estate?

So maybe you want to get a plan set up but you want to invest in real estate. Can you do this? How does this even work?

Yes you can do this. But before we move any further, let’s clarify that this cash balance plan investment strategy works best for owner-only businesses. Even having your spouse as an employee is okay. If you have employees that qualify for benefits, this plan might be a little challenging to execute.

How to invest the money?

Here are 5 steps you should consider when forming an investment strategy:

  1. Determine if you want a professional advisor or a discount firm

    You might already have a financial advisor or you may just be looking to open an account with Schwab, Fidelity or Vanguard. In either case, make sure you consider your options carefully. You may not have the time to manage the money.

  2. Determine appropriate risk tolerance

    Cash balance plans can use almost any assets class, so make sure to consider your risk tolerance. You generally want to stay on the conservative side. But you can take some exposure to stocks.

  3. Consider different cash balance plan investment options

    Did you know a cash balance plan can invest in real estate and other alternative assets? Determine if these asset classes are appropriate for you. Insurance companies often offer specialized investments such as a Guaranteed Insurance Contracts (GICs), which gives a competitive guaranteed interest rate and provides stable value. Cash may be held in a liquid form to pay current benefit payments.

  4. Don’t forget the interest crediting rate

    Remember that you have an assumed interest crediting rate. In theory, you should try to match this rate. But in practice, it is challenging to mimic the interest crediting rate. But that is fine as long as you don’t have huge volatility in plan assets.

  5. Monitor plan investments

    An annual review should be completed with your financial advisor to make sure that you investments are on track. Investment balances will be evaluated by the actuary at the end of the year and formal appraisals may be required. Ensure that you review the investment portfolio continually to prevent overfunding.

What custodian should I use?

As you know, we are not investment advisors. As such, I’m not going to give you any investment advice or stock tips. Our plans are completely portable and you can use them with basically any provider. This includes Charles Schwab, Fidelity and Vanguard. We can even help you get your account set up with them.

Charles SchwabSchwab makes it easy because we have a representative that we can work directly with when setting up a plan.
FidelityFidelity has been taking much longer recently to set up a new account. But their customer service group has made improvements.
E*TRADEStill the smallest provider. But many people rave about them.
VanguardVanguard is probably the #1 custodian we deal with.

Finalizing your cash balance plan investment strategy

Cash balance advisors play a vital role and can offer flexible investment options on their platforms. These custodians don’t always provide the most diverse investment options, but they will provide for easy set up and administration.

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Many businesses don’t realize that our plans can be used with any of these providers. Our plan documents can be used to open up an account in as little as a few days.

That allows you to get our structuring and planning services in combination with the cash balance plan investment strategy of the large discount brokerages. So don’t hesitate to consider Vanguard, Fidelity or Schwab.

Bottom Line

Companies with a cash balance plan must communicate their objectives and unique investment goals. Assuming all employee census data and actuarial variables remain constant, investment returns that exceed the interest crediting rate will tend to lower future plan contributions. 

Investing assets conservatively to meet their funding goals is critical for companies looking to manage tax exposure. We know that market conditions change quickly. As such, an active, hands-on approach aligned with the plan funding goals can help meet the objectives over the life of the plan.

So at the end of the day you have plenty of investment options. While you want to maximize your investment returns, try to avoid too much volatility. This can cause wide swings in contribution amounts.

Make sure that you deal with an investment advisor or plat form that understands the investment risks associated with these plans. That way you can sleep at night.

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Paul Sundin

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