In designing a Cash Balance Plan, one of the most pivotal decisions is selecting the interest crediting rate (ICR). This rate determines how much “interest” is credited annually to each participant’s hypothetical account, and impacts both benefit growth and employer funding obligations. Understanding how the ICR works—and the options available—is critical for plan sponsors and participants alike.
While cash balance plans are legally defined benefit plans, the interest crediting component gives them the feel of a defined contribution plan. The plan sponsor guarantees the rate of growth rather than linking the participant’s balance directly to market performance. That promise introduces both opportunity and risk: the clearer the rate, the more predictable the benefit; yet the liability for the employer becomes more tangible.
This article explores the different interest crediting rate structures, the regulatory constraints surrounding them, and best practices for choosing an appropriate rate. Whether you are designing a new plan or reviewing an existing one, a firm grasp of how interest credits work will help optimize benefits, manage costs, and align retirement objectives.
What is an Interest Crediting Rate?
Unlike a typical 401(k), cash balance plan returns are not subject to individual discretion. The plan’s crediting rate is specified and guaranteed by the sponsor. Participants receive this set rate, regardless of actual investment performance.
Before reviewing specific methods for determining the crediting rate, note that plan sponsors may use a fixed interest rate (e.g., 4%), a variable rate (such as the 30-year Treasury rate plus 0.5%), or a market rate (like an S&P 500 index fund return). IRS regulations allow variations on these two fundamental approaches.
Each method has pros and cons, often favoring participants over employers. For instance, participants may prefer a rate of 7% to 4%, but employers, bearing the risk of shortfall, may hesitate to offer higher rates.
Having discussed key pros and cons, consider how market-rate options (like S&P 500 returns) can appeal to participants seeking higher returns. Nonetheless, administrative and regulatory complexities often discourage employers from adopting these rates.
A multiple-owner firm, such as a medical or legal practice, must pass annual nondiscrimination tests. With market rates, testing uses last year’s index return. If the S&P rises 15% one year and then falls 11%, annual partner contributions fluctuate widely.
Minimum or maximum rates reduce, but don’t eliminate, unpredictability and introduce drawbacks. For example, maintaining a 3% cumulative minimum is difficult if the S&P drops 11%.
Fixed vs Variable?
Given these challenges, comparing fixed- and variable-interest crediting to market-rate approaches is useful. Most cash balance plan sponsors find fixed or variable rates more effective due to the fewer risks and uncertainties associated with them compared to stock market rates. This often benefits both sponsors and participants.
For example, an individual with 75% equities and 25% fixed income in a 401(k) might opt for 100% equities if using the cash balance plan for fixed income, or maintain their mix to gradually reduce stock market risk as retirement nears.
Financial advisors often recommend increasing fixed income near retirement. Target Maturity funds do this automatically, and boosting cash balance plan contributions adds stability.
Fixed income in cash balance plans can have variable crediting rates. While interest rates are low, variable crediting based on benchmarks like the 30-year T-bill plus a margin can still fluctuate in response to rate trends.
At retirement or another event, participants can roll cash balance funds into an IRA or leave them in the plan for steady distributions, avoiding market swings.
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Market Rate Crediting
The main advantage of market-rate crediting, compared to fixed or variable crediting, is its greater potential for upside. Under a market-rate approach, each year’s interest credit is tied to investment performance.
For example, the credited rate might track the Vanguard S&P 500 Index Fund, the Fidelity Magellan Fund, or a customized fund. In comparison, fixed and variable approaches cap potential returns but offer more predictable outcomes. This trade-off between possible high returns and predictability is central to choosing a crediting approach.
For those seeking long-term stock market potential, market-rate crediting offers the upside of higher returns, while risk remains manageable through allocation adjustments in their 401(k) plans.
Cash balance plan rules require cumulative credits to be at least zero, protecting participants from negative returns. However, high crediting rates may sharply reduce or even eliminate future contributions for those nearing IRC 415 limits.
For sponsors, comparing approaches is challenging. As noted, market-rate crediting complicates nondiscrimination testing compared to fixed or variable rates, resulting in contribution swings—especially problematic for partnerships with individual allocations.
If my plan targets $125,000 annually, market-rate credits—10%, 0%, or 22%—could swing my contributions from $125,000 to $140,000 to $70,000. How do partners plan for such volatility?
Hybrid Crediting Rate
One client limited fluctuation by using a conservative, mostly fixed-income portfolio with minimal stock exposure. Their plan credits actual returns, capped at 5.5%, making it a hybrid market-rate method based on portfolio results.
Is a Cash Balance or Defined Benefit Plan Right For You?
With only 10% market exposure, the portfolio is largely fixed income, resulting in lower fluctuations. Had it been used in the last 15 years, annual returns mostly ranged from 4.0% to 5.5%, with the only dip below 2.9% in 2008.
This approach tries to capture attractive features of both variable interest and stock market-based methods. Participants enjoy some upside tied to stocks, alongside fluctuation from fixed income rates, though the rate is capped at 5.5%. In any case, participants are protected from negative cumulative crediting rates.
From the plan sponsor’s point of view, the portfolio underlying this approach should be less volatile than a purely stock market-based rate, offering more confidence that contributions will not vary significantly due to IRC 415 and 401(a)(4) tests. Because the crediting rate reflects the portfolio’s performance, there is minimal risk of underperforming the credited rate (as might happen with a 4.0% fixed rate when actual earnings are only 1.0%). This hybrid method has been effective for our client in part because the plan is comprehensive and can easily comply with relevant testing requirements.
Smaller employers near the 415 threshold or those testing limits may still face compliance issues from even minor credit fluctuations.
Final Thoughts
When the IRS released cash balance plan crediting rate guidance in October 2010, there was initial buzz about using market-rate approaches for compliance. Despite excitement about market-based crediting and the possibility of higher returns, most plan sponsors continue to prefer the predictability and stability offered by conservative fixed or variable approaches.
As the cash balance plan landscape evolves, hybrid methods—capturing both growth potential and predictable contributions—may become more prevalent as a middle ground between the risk of market-based and the certainty of fixed interest options.
