Market Based Cash Balance Plan: The Simple Guide


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Market-based cash balance plans are a twist on our favorite retirement structure. They have been used extensively for certain employers but have been overlooked by many others.  

This plan allows for sharing investment risk, similar to how it’s done in a defined contribution plan. 

Since their introduction, MBCB plans have grown popular among professional service organizations and partnership groups. Yet many companies have basically ignored them. They go with a traditional cash balance plan or just stick with a safe harbor 401k plan.  

Background

Cash balance plans accrue benefits that are payable at a future date. Like a defined contribution plan, the employee’s benefit is based on the value of their “individual” account.

Market-based plans are a type of cash balance plan where the account’s growth is tied to the actual return on plan assets. This contrasts with a traditional cash balance plan that typically has a fixed interest credit rate.

Market-based cash balance plans are popular with professional service businesses with many partners. This included physician groups and law firms.

Cash balance plans must have an investment vehicle to accumulate assets and pay benefits when they become due. An essential part of the administration of a defined benefit plan is the oversight of transactions occurring during the year.

Investment Options

This is accomplished through an asset reconciliation, and it is a process by which potential issues are discovered and resolved. This chapter will review the different components of asset reconciliation. We will explore the difference between the use of market value and smoothed value of assets.

In addition, there will be an overview of how asset reconciliation is used to determine the rate of return, which is required for both funding purposes and government forms. This chapter will provide an overview of varying types of investments.

The named trustee in the plan document is ultimately responsible for managing the investments, delegating this responsibility, and hiring and monitoring investment service providers that assist in this regard.

Rate of Return

The rate of return is the percentage increase in the asset value due to investment performance. In general, there are many ways to calculate a generic investment return. However, we are referencing a specific method that the IRS requires for this discussion.

It considers cash flow through the year (such as benefit payments, expenses, and contributions). It measures how well the assets increased due to investment activity. It is usually determined for one year.

chart with finance, tax and debt

Depending on the plan’s asset allocation, the expected asset return will
be higher or lower than the actual asset return. If it is invested conservatively, then the actual rate of return should be stable, eliminating volatility that produces very high or low returns.

In other words, investing conservatively should eliminate deviation and produce a relatively steady rate of return. On the other hand, if the assets are invested aggressively
(e.g., 100% in stocks), the expected return will likely be more volatile and could produce more significant swings in actual return or loss.

Review of the calculation

In the simplest example, if there is $1,000 at the beginning of the year and $1,100 at the end of the year, then the rate of return is determined to be (1,100/1,000) – 1 = 10%. There are no contributions, benefit payments, or expenses in this example.

For determining the rate of return, it does not matter if the return was a result of interest, dividends, or appreciation. Only the market value of assets is considered.

The rate of return is needed so that the plan’s funded status can be explained from year to year. If asset returns are less than expected, the plan’s funding must generally be increased to compensate for the low return. This means that additional employer contributions will be required to pay for the poor asset performance.

The rate of return is also needed during the actuarial valuation for determining funding balance amounts. In addition, if the plan sponsor would like estimates of future funding levels, future rate of return estimates must be used for a market based cash balance plan.

The first step in determining the rate of return is to perform a thorough asset reconciliation. The rate of return is a time-weighted return that considers the actual date of the transactions during the plan year.

Market Based Cash Balance Plan Allocation

Asset allocation between bonds, stock, and cash is a plan sponsor’s decision. The formula for the rates of return is:

Rate of return = (I) / (A + C – B – E)

Where I is the investment return during the year, including an offset for investment expenses; A is the beginning of year market value; B is the weighted value of distributions; C is the weighted value of the contributions, and E is the weighted value of the administrative expense.

Each transaction must be weighted for the time between the transaction’s date and the end of the year. Let’s take a calendar year example: if the transaction occurred on April 1, then the weighting would be ¾; on July 1, then the weighting would be ½; or on October 1, then the weighting would be ¼. The transaction amount is then multiplied by the weighting to determine a weighted value.

Paul Sundin

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