How to Freeze a Cash Balance Plan or Defined Benefit Plan in a Few Easy Steps!

Did you know you can freeze a defined benefit plan or cash balance plan? But why would you want to do this and how does it work?

Let’s assume you set up a cash balance or defined benefit plan and make significant annual contributions. Then your situation changes. Either you’ve added a lot of employees, or your income has temporarily dropped. What options do you have?

When you set up a defined benefit plan, you always have the ability to freeze it at some point in the future. We will address this in this post.

Here is a quick summary and then we’ll get into specifics.

How to Freeze a Defined Benefit Plan:

• Your plan administration should have a checklist of items that must be completed for the freeze. The first step is to amend the plan document.
• Determine whether you want to do a “hard” freeze or a “soft” freeze. This will have a large impact on future benefits.
• If you decide to maintain the plan for current employees, but not for new employees, you must freeze the benefit formula. This allows the benefits employees will receive to be based on their compensation and service years up to the freeze date.
• Avoid IRS anti-clawback rules by not reducing benefits that have been accrued. You can always decrease future accruals on a prospective or going-forward basis.

Table of contents

• Why would you freeze a plan?
• How do you freeze a defined benefit plan?
• What is the difference between a hard freeze and a soft freeze?
• Takeaway

Some background

A cash balance plan is a defined benefit retirement plan that is becoming increasingly popular among employers. It operates like a traditional pension plan, where the employer contributes a set amount to the employee’s retirement account each year.

However, instead of promising the employee a set amount of monthly payments in retirement, as with a traditional pension plan, a cash balance plan provides the employee with an account balance, much like a 401(k) plan.

The employer sets a “pay credit” and an “interest credit” in a cash balance plan each year. The pay credit is a percentage of the employee’s compensation added to the account balance each year.

The interest credit is a set interest rate added to the account balance. These contributions grow tax-deferred and compound over time, so the employee’s account balance continues to grow until retirement. When the employee retires, the cash balance plan provides them with a lump sum payout based on their account balance.

The employee can then take the lump sum and roll it over into an IRA or 401(k) plan, or they can receive a monthly annuity payment. The annuity payment is typically based on the employee’s life expectancy and the current interest rate environment. Overall, a cash balance plan provides a more predictable retirement benefit for employees than a 401(k) plan, while still offering some of the flexibility of a defined contribution plan.

Why would you freeze a plan?

The company has the option to voluntarily change plan provisions at any point. This is done by amending the plan. In some cases, the sponsor would like to improve benefits. In other situations, the company may want to reduce future benefits that are not yet earned.

It generally is not possible to reduce benefits that have been accrued due to the IRC anti-cutback rules. It is, however, well within the plan sponsor’s rights to decrease future accruals on a prospective basis.

For example, if your plan accrued a $5,000 pay credit for anyone who works over 1,000 in a given year you cannot in December of the year decide to freeze the plan in order to eliminate this accrual. Presumably, your employees have earned this benefit so you cannot take it away from them retroactively. But you could in December decide to freeze the plan for future years. It is possible to reduce future benefit accruals to zero as long as the employer gives notice to the participants ahead of time.

How do you freeze a defined benefit plan?

Freezing a defined benefit plan means that the plan will no longer accrue new employee benefits. Employers typically freeze their defined benefit plans to reduce costs or to shift employees to a defined contribution plan, such as a 401(k). Freezing a defined benefit plan can be a complex process, and there are several steps that an employer must follow to do so.

First, the employer must communicate the freeze to plan participants and obtain approvals from the plan’s trustees or other governing bodies. Next, the employer must determine how to treat employees already accruing benefits in the plan. In some cases, the employer may continue to provide benefits to these employees based on their current plan balance. In contrast, in other cases, the employer may terminate the plan and purchase annuities for employees.

If the employer decides to continue the defined benefit plan for current employees but not for new hires, they must freeze the plan’s benefit formula. This means that the benefits employees receive will be based on their salary and years of service up until the freeze date. Employees who continue to work for the employer after the freeze no longer accrues benefits under the defined benefit plan. Still, they may be eligible to participate in a defined contribution plan.

Freezing a defined benefit plan can be a complex and time-consuming process. Employers should consult legal and financial professionals to follow all necessary regulations and best practices.

As stated previously, the freeze is completed by completing a plan amendment. Your third-party administrator can take care of this for you. This part is usually pretty simple.

What is the difference between a hard freeze and a soft freeze?

The first step is deciding what type of freeze you would like. There are two types of freezes: a hard freeze or a soft freeze.

A hard freeze is when the employer freezes the accrued benefit as of a certain date. The benefits accrued up until that date are finalized based on salary and service history to date using the benefit formula on the day of the freeze.

After that date, no further accruals occur. Even if a participant works for the employer for many more years and receives regular salary increases, it will not change the benefit payable to the participant beyond the date the plan was frozen.

Usually, when a plan is frozen in this manner, no new participants are allowed to enter the plan as of the date of the freeze. If no new participants are allowed to enter the plan, new hires do not need any information about the plan.

A soft freeze occurs when a certain aspect of the plan is frozen. For example, participation might be frozen, but benefits for the currently active participants continue to accrue going forward. In this manner, liabilities are limited to the current group. After a certain date, no new participants can join the plan, and eventually, there is no one left in the plan. This is referred to as a closed group.

Another type of soft freeze occurs when pay or service is frozen (but not both). (A hard freeze occurs if both pay and service are frozen, resulting in a frozen benefit.) The plan sponsor can freeze pay and allow service to continue.

In this manner, benefit determinations are made up of salary history to the date of freeze while using all service to exit date. Alternatively, the plan sponsor could freeze service and let pay continue. In this case, no additional years of benefit service are credited in the benefit calculation. Still, historical pay is used through termination of employment, which gives the participant a form of wage inflation adjustment.

How do you terminate or freeze a defined benefit plan?

It’s important to note that terminating a defined benefit plan can have significant legal and financial implications for the plan sponsor. It’s recommended to seek the advice of legal and financial professionals before taking any steps to terminate a defined benefit plan.

Takeaway

A freeze acts to limit the employer’s ultimate liability and reduce the cost of employee benefits. The most extreme case is a hard freeze. Soft freezes can be any one of three basic styles: frozen pay, frozen service or frozen participation.