When a new cash balance plan crosses the desk, the conversation almost always turns to one question: how much can we earn?
Business owners seek higher returns, and a market-rate interest crediting rate sounds like the obvious answer. Why settle for the sleepy 30-year Treasury rate or a flat percentage when the market can deliver so much more?
But here’s the catch: in the world of cash balance plans, what looks like upside can quickly turn into a minefield. Market-rate interest crediting introduces volatility into the testing, drives up profit-sharing allocations in strong years, and can quietly push a plan toward overfunding — complete with a 50% excise tax penalty waiting at the door.
The Appeal of Market-Rate Interest Crediting
New cash balance plans typically emerge when investment advisors recommend them to potential sponsors. When reviewing a proposed plan, clients and advisors may seek higher investment returns and hesitate about strategies that use a fixed interest crediting rate or the 30-year Treasury rate.
Instead, they may prefer an investment approach that maximizes returns, tying the interest crediting rate to a market return. However, for small plans, linking the interest crediting rate to a market return may carry more risks than advantages.
The irony is that the most common fixes for these problems — caps, floors, separate crediting rates for staff, and more conservative investment strategies — end up mimicking the very flat-rate or 30-year Treasury approach the sponsor rejected in the first place. So before locking in a market rate of return, it’s worth asking a harder question: is the upside really worth the complexity, or is there a smarter path from day one?
How Testing Works Under Different Crediting Rates
Broadly speaking, 401(a)(4) testing for cash balance plans projects start- and end-of-year balances to normal retirement age using the plan’s interest crediting rate, then converts these to monthly benefits to determine the accrual for the testing year.
With an interest crediting rate set at a flat rate or the 30-year Treasury rate, annual and monthly benefit accruals remain stable and predictable. This gives the client a clear understanding of the staff’s required annual profit-sharing allocation percentages.
Testing Challenges with Market Rates
But under a market-rate interest crediting rate, cash balance accounts are based on the current year’s asset return. Since owners and HCEs typically hold larger balances than staff, they receive proportionally greater monthly accruals. As a result, nondiscrimination testing suffers in high-return years, resulting in larger profit-sharing allocations that satisfy IRC Section 401(a)(4).
On the other hand, with a market-rate interest crediting, annual volatility increases when the population’s age distribution differs from the normal retirement age or during low-return years. This increases the need for frequent 11(g) amendments and unpredictable costs.
The Overfunding Trap
Typically, when a plan sponsor selects a market rate of return as the interest crediting rate, the driving factor is achieving high asset returns. In some ways, the cash balance plan is viewed as a defined contribution plan in which the plan’s investment returns are ‘their money.’
Also, to maximize asset returns, they choose to fund the plan as much as possible (often up to the Section 404 maximum deductible contribution). High asset returns and maximum contributions eventually become incongruous as cash balance accounts approach the IRC Section 415 limit.
Left unmonitored, the cash balance plan can quickly become overfunded. Plan sponsors and advisors who are unaware of their plan actuary’s assessment of overfunding risks are often surprised to discover the limits on distributions. Equally startling is the excess asset discussion and a 50% excise tax penalty.
Strategies to Mitigate Market-Rate Risks
Several approaches can reduce risks tied to market rates of return, such as the interest crediting rate.
Use EMPARION PLANS on
*Emparion is not affiliated with, endorsed by, or sponsored by these institutions.*
Excess assets can be reduced by changing the plan’s investment and contribution strategy as excess assets become more prevalent over the plan’s life. IRC Section 401(a)(4) risks can be controlled by putting a cap on the interest crediting rate to not exceed the testing interest rate (which is usually 8.5%) and a floor (say 3.00%) to protect in low return years. IRC Section 401(a)(26) issues can potentially be avoided by assigning a different interest crediting rate to the staff (keeping in mind the need to satisfy availability of benefits, rights, and features under IRC Section 401(a)(4)-4).
Note that setting a floor/cap on the interest crediting rate and assigning different rates to the owner and staff increases administrative complexity beyond what is already required for a plan with a true market rate of return.
Reconsidering the Rationale for Market Rates
However, if mitigating market-rate-of-return risks means setting a floor or cap, granting staff a different interest crediting rate, and choosing a more conservative investment or contribution strategy, then why not simply adopt a flat or 30-year Treasury interest crediting rate from the beginning? If controlling market-rate-of-return risks leads to an approach echoing a flat or 30-year Treasury rate, the rationale for selecting a market-rate-of-return interest crediting rate at all must be questioned.
The Actuary’s Role in Setting Expectations
When an employer adopts a cash balance plan, selecting the interest crediting rate is an integral plan provision. While setting the interest crediting rate as a market rate of return sounds optimal, doing so could carry significant risks.
Depending on a plan sponsor’s size, demographics, and contribution goals, a flat or 30-year Treasury interest crediting rate could be a more sensible choice. When an actuary is contacted to implement a cash balance plan with a market-rate of return as the interest crediting rate, they must clearly convey the risks and complexities of this approach to the plan sponsor and investment advisor.
The Bottom Line
Choosing an interest crediting rate isn’t just a technical box to check when designing a cash balance plan — it’s a decision that shapes every year of the plan’s life, from nondiscrimination testing and contribution requirements to long-term funding health and exit strategy. A market rate of return may look attractive on paper, but for most small plan sponsors, the trade-offs in volatility, administrative complexity, and overfunding risk simply don’t justify the upside.
That doesn’t mean a market-rate approach is never the right call. It means the decision deserves a clear-eyed conversation up front — one that weighs the sponsor’s demographics, contribution goals, time horizon, and tolerance for surprises against the alternatives. In many cases, a flat rate or the 30-year Treasury rate quietly delivers what sponsors actually want: predictability, manageable testing results, and a plan that funds the way it was designed to fund.
Is a Cash Balance or Defined Benefit Plan Right For You?
Before committing to an interest crediting rate, talk with an experienced actuary and plan consultant who can model the long-term implications under different scenarios. The right choice today can save years of amendments, unexpected contributions, and excise tax headaches down the road — and that’s a return on planning that’s hard to beat.
