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. They still provide the same tax deduction benefits.
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.
Table of contents
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.
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.
Fixed-Income Investments
Fixed income investing is an investment that pays a set interest rate. This is because governments and companies use it as a means of raising funds for large projects or operations.
Fixed income investment vehicles are not like savings accounts, in that they require a regular withdrawal. You may have to surrender some of your investment at maturity or risk paying a penalty. Another risk is interest rate risk, which means you may lose money if the interest rates in the market change.
Fixed income investments can be made by borrowing money from the federal government and other financial institutions. The federal government issues Treasury bonds and is arguably the safest type of bond for fixed income investing, because they have a long maturity.
In contrast, high-yield bonds, also known as junk bonds, are more risky. They tend to offer higher interest payments than investment-grade bonds. However, you can diversify your investment portfolio with these investments.
As retirement approaches, advisors often recommend allocating some of your investments to fixed income investments. This reduces your overall risk and simplifies retirement budgeting. This works well in a market based approach.
But if you are worried about the volatility of the market, fixed income investments may be right for you. While you should keep in mind that bonds do have some risks, they are much lower than stocks.
Building a Diversified & Conservative Portfolio
Choosing a conservative dividend portfolio can help you achieve your investment goals. The average yield of a DGI portfolio is 3%, and it takes about five years for it to start throwing you income in the 4-5% range as an illustration.
Dividend reinvestment and yearly dividend increases will increase your starting yield. Investing in REITs and higher yielding, safe stocks will also help. But remember that there is a risk. Dividends can go down as well as up, so you should be able to tolerate them.
A conservative dividend portfolio will also have some commodity exposure. While such investments may seem risky, the beta on these companies is so low that you can have substantial exposure to them.
While the initial bond/stock mix depends on your risk tolerance and return goals, there are certain benchmarks that you can follow to achieve meaningful income in retirement. A conservative dividend portfolio consists of quality dividend stocks that collectively yield 3% or more and increase their dividends by 3.5% annually.
This yield is high enough to offset the risk of inflation and still maintain a high income stream. With a little work, you can build a conservative dividend portfolio that yields between 4% and 4.5%. By doing this, you’ll have income security and diversification without the risk of losing your nest egg. You won’t have these same restrictions in a Mega Backdoor Roth.
Determine Proper Investment Allocation
The trustee can manage the investments directly or delegate the investment management to a third party. A typical asset allocation for a defined benefit plan is 60% stocks and 40% bonds. Ultimately the trustee will want an asset mix that will closely align with expected future benefit payments.
Questionable investments could include paintings, coin collections, baseball cards, and real estate, to name a few. These investments may not meet the trustee’s requirement to act in the sole and best interest of the participants for their benefit.
Furthermore, it may be challenging for the trustee to prove they acted prudently in selecting such an investment. As these investments do not have a well-established market value, do not trade on regulated exchanges, and are not liquid, there may be additional requirements for the trustee, including an appraisal by an independent third party. This can add cost and complexity to the administration of a plan with these investments.
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 expected 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 that will cover liabilities, provide a consistent return and limit risk in the form of increased contributions to the plan sponsor.
How to Structure a Market Based Plan
Here are the 5 steps to setting up a plan based on market or actual returns.
- Compare risks of market based plan to fixed interest credit
Remember that actual-rate plans are tied to the actual return on investment assets. This compares to a traditional cash balance plan structure that uses a fixed interest crediting rate. We have discussed the pros and cons of each structure in great detail.
- Examine impact with employees
A company willing to contribute 5-7.5% to employees is a good starting point. Motivating employees with a cash balance plan can be great for morale. In addition, the owner can consider vesting options that can improve retention while offering deductions for the plan sponsor.
- Don’t forget the benefits of a fixed rate
Rather than relying on a specific rate of return from the stock or bond market, the employer guarantees these interest charges as a return on investment for the employee. The plan documents define the interest credit. It is usually approximately 4% – 5% as a general guide. But they maintain individual employee accounts like a defined contribution plan. The company will make annual contributions. Employees do not bear any investment risk.
- Determine portfolio mix
A wide range of investments is allowed in defined benefit plans. These include stocks, bonds, and cash. Each of these may be held directly or through a mutual fund. Cash may be held in a liquid form to pay current benefit payments.
More exotic varieties of investment are also allowed; however, plan sponsors should exercise caution when considering varying asset types such as commodities, real estate, collectibles, and derivatives. The 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. - Review with CPA and administrator
Your CPA is in the best position to analyze the impacts of the different structures. You should also consider the desired investments. You want to still be conservative with assets allocation, but a market-based approach will be able to effectively address higher plan returns.
| Calculation | Amount |
| Beginning of year balance | $30,000 |
| Market or actual rate | 10% |
| W2 salary | $100,000 |
| Pay credit | 5% |
| End of year balance | $38,000 |
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.
