A solo cash balance plan can select many different interest crediting rates. This includes fixed, variable and even market-based.
At first glance, market-based interest crediting seems to make a lot of sense. But once you take a closer, you will uncover many pitfalls.
In this post, we will discuss why we do not recommend market-based interest crediting for solo plans. We’ll spell out the pros and cons so you can make the best decision for your plan!
Appeal of Market-Based Interest Crediting
Market-based plans are legal and can work in the right setting. On paper, it sounds more logical than a fixed rate. Many owners assume it will make the plan easier to manage and allow them to get higher contributions.
They want more upside than a lower fixed interest crediting rate. After all, it would appear that you can make larger contributions with a 10% pay credit rather than a 5% pay credit. Most people want to do this to aim for higher investment returns.
Some owners assume a market-based rate will create steady contributions. They believe the plan will adjust naturally with investment performance. That belief sounds reasonable, but it oversimplifies the funding of defined benefit plans. It also fails to consider the interaction between pay credits and interest credits.
Dealing with Gains & Losses
If asset returns are stable, there are usually few issues. But are high investment gains stable? Of course not. The desire for high investment returns means you are accepting high volatility. That’s where the problem starts.
The real issue begins with volatility. Higher expected returns usually come with larger swings in annual results. A solo plan owner may enjoy strong upside years. However, they may not fully appreciate how those swings affect future required contributions.
A market-based rate amplifies the effect on the short-term market rate as it’s used to project to retirement age. A loss will project the hypothetical balance at a 0% interest rate in years when the return is low. This will decrease the minimum required contribution and maximum allowable contribution.
In contrast, a high rate of return will project that return all the way to retirement and increase the minimum required contribution. Depending on the rate, the minimum required contribution may exceed the amount you can distribute. As you can see, market-based returns can create large contribution risks.
Why the Asset-Liability Matching Theory Falls Short
Many owners like market-based crediting for another reason. They believe assets and liabilities will track each other more closely. If the market declines, they expect the liability to decline too. They assume that means they will not need to make up investment shortfalls.
That theory sounds attractive, but it does not fully work in practice. A cash balance plan is not just an investment account. It is a defined benefit plan with a promised formula. The plan’s liability depends on more than market performance alone.
When looking at market-based plans, many people focus only on the role of the interest credit and ignore the pay credit. Each year, the plan adds a new promised benefit. That promise exists regardless of that year’s investment return. A market loss does not erase it.
This is where many solo owners become confused. They focus on the interest credit and fail to understand annual benefit accruals.
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Example
Let’s assume a 50 year-old business owner has a W-2 of $100,000 and a pay credit of $70,000 for two years in a row. They are considering whether to use an interest crediting rate of 5% or a market-based rate with a zero percent floor.
5% Interest Credit
Let’s assume the investment account went up exactly 5% and so the hypothetical account balance equals the contributions. Using a 5% interest crediting rate, here is what the participant account balance is at the end of the second year:
| Credit Applied | Account Balance |
|---|---|
| Two years of pay credits | $140,000 |
| Interest credit applied on year 1 credit | $3,500 |
| Ending participant account balance | $143,500 |
| Investment balance | $143,500 |
| Shortfall | $0 |
Market-Based Credit
But now let’s assume a market based plan that lost 10% on the investment account each year and has the zero percent floor:
| Credit Applied | Account Balance |
|---|---|
| Two years of pay credits | $140,000 |
| Interest credit applied on year 1 credit | $0 |
| Ending participant account balance | $140,000 |
| Investment balance | $126,000 |
| Shortfall | $14,000 |
As you can see from the above, there would be a shortfall in the investment account and the business owner would have to make a contribution to catch up. That’s because the investment losses “ate into” the pay credits.
Remember that the pay credit is guaranteed to the participant. You can’t just tell the participant that the plan trustee lost all the money and their retirement is gone!
Using Floors and Ceilings
A floor or ceiling can be added to a market-based cash balance plan to reduce annual volatility. For example, the plan might credit the actual return, but never less than 2% and never more than 6%.
That means a poor market year would still produce a modest positive credit, while a very strong year would be capped before it creates an excessive increase in the projected benefit. This approach can help smooth out some of the more extreme swings in annual funding calculations.
Is a Cash Balance or Defined Benefit Plan Right For You?
A floor is mainly used to protect the participant from very low or negative returns. If the market performs poorly, the floor ensures that the hypothetical account still receives a minimum interest credit.
A ceiling works in the opposite direction by limiting how much of a high return is recognized under the plan formula. That can help prevent a single strong year from causing a sharp increase in future minimum required contributions.
Even with a floor and ceiling, the plan is still more complex than a fixed-rate design. The owner must understand that the contribution results can still change from year to year based on market performance within that range.
In other words, the floor and ceiling can reduce extremes, but they do not eliminate the extra variable created by a market-based formula. That is why many solo plan owners still prefer a fixed interest crediting rate.
Comparing the Two Approaches
Here is a simple comparison of fixed and market-based crediting rates:
| Feature | Fixed Interest Crediting | Market-Based Interest Crediting |
|---|---|---|
| Annual predictability | Generally more stable | Often more variable |
| Funding clarity | Easier to explain | Harder to model and explain |
| Contribution volatility | Usually lower | Can be significantly higher |
| Ease of administration | More straightforward | More complex |
| Fit for solo owners | Often better | Usually less practical |
A side-by-side comparison usually makes the issue clearer. Most solo owners are not looking for an advanced actuarial strategy. They want a reliable retirement plan with strong deductions. They also want fewer variables affecting annual funding.
A fixed rate better supports those goals in many cases. It makes the plan easier to understand and maintain. The owner knows what the formula is trying to do. That confidence matters over a long planning horizon.
A market-based rate may appear more flexible at first. But flexibility is not the same as stability. In practice, volatility often creates more stress than benefit. That tradeoff rarely helps a one-person plan.
The owner should also remember the plan’s purpose. A solo cash balance plan is primarily a retirement and tax-planning tool. It is not meant to create investment drama. It should support orderly accumulation and predictable funding.
5 Problems with Market-Based Plans
Here are 5 reasons why we don’t recommend market based interest crediting:
1) Contributions become less predictable
A solo cash balance plan usually works best when annual funding is reasonably stable. A market-based crediting rate can make minimum and maximum contributions swing much more from year to year because of the more volatile investment returns.
That unpredictability makes tax planning harder. It can also create frustration when the owner expects one contribution range and the actuary calculates another.
2) Higher return potential = higher volatility
Most people choose market-based crediting because they want higher returns. The problem is that higher expected returns usually come with larger annual gains and losses.
Those swings can create funding issues that do not exist with a fixed crediting rate. In a solo plan, that added volatility usually creates more risk than benefit.
3) Actuaries are less familiar with market-based plans
Very few actuaries deal with market based plans because there is such low demand for them. As a result, they may not understand all the complexities and errors could result. Many will often charge a higher rate to address this issue.
4) The asset-liability matching theory does not fully work
Some owners believe a market-based formula will keep plan assets and liabilities aligned. They assume that if investments fall, the liability will fall enough to offset the loss.
That theory ignores the annual pay credit and other funding mechanics. A cash balance plan is still a defined benefit plan, so market losses do not automatically eliminate contribution risk.
5) It adds complexity without solving a major solo plan problem
A solo owner usually wants simplicity, stable deductions, and easier long-term planning. A market-based crediting formula adds another variable that affects annual actuarial calculations.
Even with a floor and ceiling, the plan is still harder to explain and manage. In many cases, a fixed rate gives the owner a cleaner and more practical design.
Key Design Points to Remember
The best design is usually the one you can maintain. A technically valid formula is not always the best formula. Solo owners usually need practical solutions. That is the lens we use when reviewing interest crediting options.
Before choosing a market-based formula, remember these points:
- Higher expected returns usually come with higher volatility.
- Volatility can make minimum and maximum contributions harder to predict.
- A market loss does not eliminate the effect of the annual pay credit.
- Strong returns can increase projected liabilities more than many owners expect.
- Floors and ceilings may help, but they still add complexity.
- A fixed rate often produces a smoother long-term funding experience.
It is also important to understand plan terminology clearly. The interest credit is not the same as the pay credit. The pay credit is the annual benefit accrual under the formula. The interest credit grows prior hypothetical balances.
For that reason, we usually favor the simpler structure. A fixed interest crediting rate reduces avoidable funding noise. It makes the plan easier to explain, administer, and keep. That is often the better answer for a solo business owner.
When Does a Market-Rate Plan Make Sense?
While we have discussed why these plans have some challenges, there are a few situations in which they can work well. Specifically, they can work well with: (1) larger professional service plans; and (2) frozen plans looking to minimize funding requirements.
Larger Professional Practices
Market rate plans can work for larger professional practices (i.e. a 20+ physician group with low staff). With a high-income group and a sophisticated financial advisor, the investment returns can be closely monitored.
With a fixed rate, participant statements reflect this rate and NOT the investment gains of the investment account. So if each employee is guaranteed a 4% interest credit, when they leave the group, they will receive their pay credits plus 4%, which may vary significantly from the actual investment performance.
For example, if the plan has a 4% interest credit and the investments earn 9%, the extra 5% remains in the investment account. Any excess returns remain in the plan and will not be distributed to a departing shareholder or partner.
Large, Frozen Plans
These designs can work for companies who froze their plans and want to minimize funding requirements. If you invested in an immunized bond portfolio that mimicked the plans sensitivity to interest rates, the investment returns cover the plans liability in most markets.
Bottom Line
Market-based interest crediting is legal and can work in some situations. However, we generally do not recommend it for solo cash balance plans. The design often adds volatility where stability is preferred. That tradeoff usually creates more risk than reward.
Market-based formulas can look attractive in theory. They seem to promise closer alignment between assets and liabilities. They also appear to offer a smarter path to higher returns. In practice, those benefits are often overstated.
Adding a floor and ceiling may reduce some extremes. That can make the design more manageable. Still, it remains more complicated than a fixed alternative. Most solo owners do not benefit from that extra complexity.
The simplest answer is often the best one. Choose a fixed rate and remove one major variable. Solo business owners usually prefer planning flexibility. They want stable deductions and manageable annual funding targets. They also want fewer surprises near the tax deadline. A volatile crediting formula often undermines those goals.
