LA Advanced Pension Conference WS 7: Cash Balance Update Kevin J. Donovan, CPA, EA, MSPA, ACA Pinnacle Plan Design LLC Andrew W. Ferguson, FSA, EA, MSPA Altman & Cronin Benefit Consultants, LLC 1 Today s Agenda 1. Background on Cash Balance 2. Interest Crediting Rules 3. More on 2014 Regs 4. Crediting Actual Return 5. Design Case Study 6. 415 Limits 7. Questions 2 1
What is a Cash Balance Plan? Defined Benefit Plan Benefit = Notional Account Assets are not divided into individual accounts Account is on paper only Interest credit on Notional Account E.g., 4% annual interest credit Interest credit may (or may not) match investment return on Plan assets 3 Cash Balance Example 1/1/2015 Account Balance: $100,000 Annual principal credit: $25,000 Annual interest credit: 2015: $100,000 * 3% = $3,000 12/31/2015 Account Balance: $128,000 4 2
Cash Balance Usage What does a Cash Balance Plan do well? 1. Provides significant tax deferral Generally not appropriate for lower dollar employers, for whom a DC approach might work better Stand alone, or supplement to a DC plan 2. Contributions relatively predictable No lump sum volatility, as with traditional DB plans If investments similar to interest credit, contributions volatility is dampened 5 Cash Balance Usage What does a Cash Balance Plan do well? 3. Can generate flat annual contributions for principals Depends on link between investments & interest credits Appropriate to employers with income stability 4. Favorable non discrimination for principals 35% discount on CB contributions, compared to DC plan contributions 6 3
Cash Balance Usage What does a Cash Balance Plan do well? 5. Divides costs and benefits easily among multiple principals Principal benefit = account balance Principal cost = funding of account balance Staff costs easily assignable by employee Not true with traditional DB plan, since varying ages of principals will generate different lump sum values 7 Cash Balance Usage What does a Cash Balance Plan do well? 6. Branded design Common, well known product Legal affirmation in PPA 2014 final regulations reinforce legality and regulatory acceptance of designs Lots of administrative support in industry 8 4
Cash Balance Usage What is a Cash Balance Plan NOT good at? 1. Targeting certain levels of income Traditional DB plan better with income target E.g., 10% of IRC 415 limit CB plans better with savings targets 2. Providing funding flexibility Like all DB plans, contributions required 3. Covering younger staff employees Better non discrimination value in DC plan 9 Cash Balance Usage What is a Cash Balance Plan NOT good at? 4. Providing top heavy minimum benefits Top heavy benefits more expensive in CB than in DC CB top heavy benefit is quadruple the 401(a)(26) threshold Must track lump sum value, rather than balance 5. Satisfying 401(a)(26) Must cover 40% of workforce (or 50 parts, if smaller) Staff coverage expensive, particularly for older employees Best if principals meet 40% / 50 requirement 10 5
Final Hybrid Regulations Approach to Cash Balance Regulation: Prescriptive IRS dictates specific interest rates available Interest rates outside IRS list cannot be used 2014 regs: IRS delegated the ability to issue future guidance to expand list of acceptable interest rates We may see gradual expansions of possibilities 11 Cash Balance Interest Rates Acceptable Interest Rates: 1. Fixed: up to 6.0% 2010 regs: up to 5.0% 2014 regs increase the acceptable upper limit 2. Treasury yields: Yields + fixed basis points E.g., 5 year Treasury yield + 25 basis points Similar to IRS Notice 96 8 12 6
Cash Balance Interest Rates Acceptable Interest Rates: 3. Segment rates: MAP 21 (as adjusted by HATFA) or Unadjusted First, second or third 4. Investment return on plan assets: 2010 regs: return on all plan assets 2014 regs: return on all, or on subset, of plan assets 13 Cash Balance Interest Rates Acceptable Interest Rates: 5. Investment return on mutual funds: Must be broad based Not significantly more volatile than US markets E.g., no industry sector 6. Annuity contract rates 14 7
Cash Balance Interest Rates Acceptable Minimum Interest Rates: a. Treasury yields: up to 5.0% annually E.g., Max of 30 year Treasury and 5.0% Minimum applies to each year b. Corporate bond yields: up to 4.0% annually E.g., Max of MAP 21 first segment rate & 4.0% Minimum applies to each year 15 Cash Balance Interest Rates Acceptable Minimum Interest Rates: c. Return on Plan Assets: up to 3.0% cumulatively E.g., Return on plan assets, not less than 3.0% Does NOT apply annually Applies on cumulative basis Applies at distribution only d. Return on mutual funds: Same as for Return on Plan Assets 16 8
Cash Balance Interest Rates Blended Interest Rates Can blend any collection of acceptable rates: 50% Vanguard 500 + 50% Russell 2000 return But does this make sense? Would rather blend segment and/or style funds, such as small cap, or technology Since each fund must comply by itself, this appears to be impossible Stuck with broad based single funds? 17 Cash Balance Interest Rates Blended Interest Rates (cont ) Alternative solution: Set blended rate as desired: E.g., 50% Vanguard 500 + 50% QQQ Cap it by an acceptable rate E.g., limit to 6.0% Or limit by segment rate 18 9
Cash Balance Interest Rates Blended Interest Rates (cont ) In 2014 final reg preamble, states that IRS could in the future allow: Credit investment return on plan assets, With annual floor (not just cumulative floor), With reduction in plan asset return, to adjust for cost of the annual floor E.g., max (3%, return on plan assets minus 10 bp) 19 Investment Direction? Can Investment Direction by provided? Suggested by IRS in 2010 regulations 2014 regulations: It is possible that the Treasury Department and the IRS will conclude that such plan designs are not permitted. This follows 4 pages of criticism of investment direction. We take this as No. But we could be wrong 20 10
IRS Proposed Relief What if Interest Rate is non compliant? Why do we need IRS relief? Interest crediting is a right to which participant is entitled, from now until any future point, once the contribution to which it applies has been accrued Once the 2015 contribution is accrued, the right to interest on it for all years to distribution is accrued Cannot cut back interest, even though it has not yet been credited! 21 IRS Proposed Relief What if Cash Balance Plan is non compliant? General rule: correct in most straightforward way Examples: 1. Credits 7%: cut back to 6% 2. Credits S&P 500: credit Vanguard 500 return 3. Credits 30 year Treasury yield, with floor of 6%: reduce floor to 5% Special rules apply for more complicated situations Effective January 1, 2016 22 11
Sub Pools of Assets New option in 2014 regs: Credit return on sub pool of plan assets Sub pool option intended to accommodate cash balance conversions: Sub pool 1: traditional defined benefit Sub pool 2: new cash balance benefit Or matching of assets with liabilities: Sub pool 1: active participants Sub pool 2: retirees with annuities 23 Sub Pools of Assets Asset Sub Pools: Other Applications 1. Asset allocation sub pools: Each sub pool is a separate investment policy Participants assigned to a particular sub pool Assignment is one time at design inception 2. Transitional design sub pools: Sub pool 1: match yield rate on existing balances Sub pool 2: credit plan return on new accruals 24 12
Sub Pools of Assets Asset Sub Pools: Other Applications 3. Lifestyle cash balance plan? Segment participants by age Each sub pool is a lifestyle fund Age discrimination a risk? 25 Sub Pools of Assets Requirements for Sub Pools: 1. Sub pool must be diversified: ERISA standard applies 2. 10% limit in sub pool on qualified employer securities 3. Market value of assets in sub pool must approximate the liabilities for benefits to which the sub pool relates Vague standard Two examples in regs 26 13
Cash Balance & Late Retirement DOL concerned about preservation of benefit value after Normal Retirement Age ( NRA ) If not in pay status by NRA, continued deferral causes loss of value (because of shorter expected lifespan) Example: $100 per month payable at age 65 (the NRA) Participant defers payment to age 67 Two fewer years of payment of that $100 per month In the DOL s eyes, that s a loss of benefits 27 Cash Balance & Late Retirement Four solutions: 1. Notify participants of loss of value Distribute suspension notice upon attainment of NRA 2. Gross up the benefit Increase the $100 at age 65 to, say, $114 at age 67 3. Offset gross up by continued accruals If $100 at age 65 becomes $125 at age 67 due to ongoing accruals, then no loss of value 4. Force distributions to start at NRA 28 14
Cash Balance & Late Retirement Grossing up Benefit Value Increase benefit for shortened future lifespan New benefit = (NRA benefit * a NRA ) * (1 + int) / a AA For a Cash Balance Plan, this is mathematically the SAME as crediting interest at the rate of int Assumes we can ignore mortality adjustment Can int be the Plan s interest crediting rate? If yes, then we comply automatically If no, we have more work to do 29 Cash Balance & Late Retirement 2014 Final Regulations Preamble: A [cash balance] plan that does not suspend benefits will have to provide adjustments in excess of the benefits determined if the interest crediting rate is insufficient to provide the required actuarial increases. (emphasis added) In other words, at least some interest crediting rates are not sufficient for post NRA actuarial increases 30 15
Cash Balance & Late Retirement Post NRA Actuarial Increase Standard for actuarial increase: reasonableness Are these reasonable? a. 30 year Treasury rate b. 5 year Treasury rate (current rate: 1.4%) c. 1 year Treasury rate (current rate: 0.2%) d. Actual return on assets (could be negative) 31 Cash Balance & Late Retirement Consider DOL suspension notice a. If CB Plan document already provides for suspension of benefits notice, but these notices have not been distributed in the past, can start distributing the notices Distributing notice now covers only future increases What about past increases? b. If no CB Plan document language on suspensions: Use wear away to extend notice coverage to existing account balance and still preserve accrued benefit 32 16
Cash Balance & Late Retirement Consider DOL suspension notice c. Suspension notices do NOT work after age 70 1/2 Force distributions starting at age 70 1/2? Or credit additional interest? d. Suspension notices do NOT work if the participant works less than 40 hours per month Force distributions if hours fall below this threshold? Hours measurements can be painful 33 Plan Termination Plan Termination: Statute Interest = 5 year average of interest crediting rates Plan Termination: 2010 Regs If crediting return on assets or mutual funds, Interest = 5 year average of 3 rd segment rates Plan Termination: 2014 Regs If crediting return on assets or mutual funds, Interest = 5 year average of 2 nd segment rates 34 17
Plan Termination In determining 5 year average: Determination of whether any rate used in average is a market rate is based on time rate applied and not year of termination Minimums, maximums, etc. recognized But not cumulative minimums Per PBGC guidance, if final year is a short year, ignore final year rate in average Still use final year rate for crediting to termination date 35 Plan Termination Example: Lesser of 30 year Treasuries (previous Oct) and 4.00% October 2014 3.04% October 2013 3.68% October 2012 2.90% October 2011 3.13% October 2010 3.87% October 2009 4.00% (actual 4.19%) Plan terminates April 1, 2015 Interest used post termination would be 3.52% Average: 3.68%, 2.90%, 3.13%, 3.87%, 4.00% Oct 2014 rate ignored in average 2015 is not a full plan year 36 18
Cash Balance Conversions Cash Balance Conversions Converting from a traditional defined benefit to a cash balance design is highly regulated 2010 Regs proposed a narrow slice of relief: Set and forget Because the application of this relief is so limited, 2014 Regs retract the relief Special rules for those who employed the 2010 Reg relief in the interim 37 What s Missing from Regs How to Project the Interest Credit Accrued benefit: interest projected to NRA Accrued benefit is the basis for compliance: Non discrimination testing IRS benefit limits ( 415 limits) Accrual rules Most significant compliance item is still unknown! 38 19
What s Missing from Regs Projection of Interest Credit IRS position (verbal) position: Project interest at current rate Does it make sense to project an equity portfolio s returns for all future years at current rate of return? 2014 S&P 500 return: 13.7% Project for all years after 2014 at 13.7%? 39 Interest Rate = Actual Return Advantages in crediting Actual Return? 1. Assets and liabilities match each other Contributions more aligned with pay credits Investment risk mostly shifted to participants 2. May lower risk under IRC 401(a)(26) Potential for fewer gains and losses to allocate among partners, potentially reducing perception of individual plans by IRS 40 20
Interest Rate = Actual Return Assets and liabilities match each other Can deposit pay credits, and account balances are based on actual investment earnings Just like money purchase plan But not exactly: Preservation of capital Likely need interest cap to pass 401(a)(4) & 415 Timing of deposits may be restricted 41 Interest Rate = Actual Return Interest crediting rate can be Negative! If interest credit a flat rate, or tied to outside index, what happens when an investment loss occurs? 1. Plan sponsor contributes additional amounts 2. Principals complain about that! If crediting Actual Return, investment loss is passed through to account balance 1. Assets and liabilities remain in alignment 2. Principals not disturbed by any cash calls Watch out for Preservation of Capital 42 21
Interest Rate = Actual Return Challenges for Actual Return (or mutual fund return) 1. Greater administrative work 2. Uncertainty with accrued benefit 3. Potential difficulties with Top 25 lump sums 4. Potentially lower 415 Limits 5. Potentially harder to pass 401(a)(4) 6. Potentially harder to meet 401(a)(26) 7. Timing of contributions 43 Crediting Return Challenges Potentially harder to pass IRC 401(a)(4) Combo plans often have: HCEs: mostly in CB Plan non HCEs: mostly in PS Plan Non d testing depends on leverage Typical HCEs: 4.0% projection in CB Plan (*) Typical non HCEs: 8.5% projection in PS Plan * 4.0% could be flat rate, or the 30 year Treasury, etc. 44 22
Crediting Return Challenges Potentially harder to pass IRC 401(a)(4) cont If crediting Return, projection in Non d Test is asset return Per IRS, must be current year s invest return Non d test now volatile! If ROR high (e.g., 15%), testing likely fails HCEs at 15%, non HCEs at 8.5% => leverage reversed! Usually, Non d Test governed by MVAR MVAR is 8.5% projection Limit Return to no more than 8%, and testing likely OK Model testing to design Return cap that works 45 Crediting Return Challenges Potentially harder to pass IRC 401(a)(26) Need 40% / 50 participants at meaningful level Meaningful: 0.5% accrued benefit increase at NRA Low or negative returns can create problems Example: participant age 35 with $40,000 compensation At 5% = $40,000 * 0.5% * 13.0496 / 1.05 62 35 = $700 At 2% = $40,000 * 0.5% * 13.0496 / 1.02 62 35 = $1,530 Requires TWICE the contribution credit at 2% as at 5% Variable interest rate produces variable compliance cost 46 23
Crediting Return Challenges Potentially harder to pass IRC 401(a)(26) cont Need minimum rate, or not included in 40% / 50 count Already need ROR cap for 415 & 401a4 If ROR cap at 6%, and minimum at 4%, why bother? Staff: use fixed interest rate (e.g., 4%) Principals: keep at Actual Return Higher investment risk on staff benefits to earn fixed rate, but they are small benefits 47 Crediting Return Challenges Timing of contributions Where contributions not made on last day of the year, interest credits may be higher than investment returns E.g. assets earn 5% to June 30 th, and then loses 5% through 12/31 result is 0% return for the year Prior year contribution on June 30 th, so it loses 5% But prior year pay credit receives actual return from January 1 st (the 0% return for the whole year) By being made mid year, contribution is 5% short of the liability it was intended to fund 48 24
Crediting Return Challenges Timing of contributions: Solutions 1. Define interest crediting to begin at later date If contribution usually made end of March, set interest crediting on prior year pay credit to start on April 1 st. This still commits the plan sponsor to contribute on a particular date or take risk of loss 2. Define actual return as though contribution for prior plan year made on specific date IRS Regs sufficiently vague to consider? Confirm with counsel before proceeding 49 Case Study Two partners: 5.0% of pay PS contribution Want to maximize tax deferral Two associates: No profit sharing contribution In separate 401(k) plan to avoid top heavy minimum Staff: 5.0% of pay profit sharing contribution 1.5% of pay matching contribution 50 25
Case Study Category Age Pay HCE Partner 50 $265,000 Y Partner 40 265,000 Y Associate 1 32 220,000 Y Associate 2 28 220,000 Y Staff 1 55 100,000 N Staff 2 45 70,000 N Staff 3 35 70,000 N Staff 4 30 60,000 N 51 Case Study Demographics tell us 1. Match is not helpful to partner contributions Convert match to profit sharing May be sufficient for gateway need analysis 2. Older partner will get sizable CB Staff is young Need reasonably high profit sharing contributions 3. Younger partner benefits will be below IRS limit No 20 somethings among staff 52 26
Case Study Demographics tell us 4. Combined plan limit drives partner profit sharing Partner profit sharing will be small 5. Staff CB Plan coverage necessary to meet 401(a)(26) 2 partners + 2 staff meets 40% CB coverage for youngest staff (least expensive) Grant minimum CB Plan benefit under 401(a)(26) Treat CB benefits as add on, rather than reducing profit sharing 53 Category Case Study 401(k) Profit Sharing Cash Balance Partner $18,000 $14,800 $136,000 Partner 18,000 14,800 48,000 Associate 1 18,000 0 0 Associate 2 18,000 0 0 Staff 1 6,000 6,500 0 Staff 2 4,200 4,550 0 Staff 3 4,200 4,550 1,700 Staff 4 3,600 3,900 1,200 54 27
Case Study Why no Top Heavy contributions for Associates? Associates in separate 401(k) plan No keys in separate 401(k) plan Separate 401(k) plan does not help the other 401(k) plan or the CB Plan pass non discrim Therefore, no required aggregation group! See IRC 416(g)(2)(A)(i)(II) 55 Case Study More on Separate 401(k) Plans When associate promoted to owner, must transfer account balance out of separate plan If associate marries a partner, must transfer balance Hopefully, this is a known event Partnership agreement may stipulate disclosure Must perform two non discrimination tests: 1. Combination of two plans Ensures Associate only plan passes (aggregated) 2. CB Plan + Staff/Partner 401(k) plan Ensures stand alone pass for these two plans 56 28
Determination of NAR Age 50 HCE CB pay credit of $136,000 Increase from age 50 to testing age (age 62) at interest crediting rate of 4% = $217,740 Divide by APR using plan rates (5%, 2015 417(e) table) at age 62 = 156.5952 Accrued benefit = $217,740 / 156.5952 = $1,390 Normal accrual rate = $1,390 * 12 / $265,000 = 6.3% 57 Determination of NAR HCE 1 allocation of $14,800 Increase from age 50 to age 62 at 8.5% = $39,393 Divide by APR (1971 GAM male, 8.5%, age 62) = 101.7180 Equivalent benefit = $39,393 / 101.7180 = $387 Equivalent benefit accrual rate (EBAR) = $387 * 12 / $265,000 = 1.8% 58 29
Case Study CB Normal EBAR Tot Normal EBAR Category PS EBAR Partner 1.8% 6.3% 8.1% Partner 4.0% 3.3% 7.3% Associate 1 Associate 2 Staff 1 1.4% 1.4% Staff 2 3.1% 3.1% Staff 3 6.9% 0.5% 7.5% Staff 4 10.4% 0.5% 11.0% 59 Case Study 1. We pass 401(a)(26) Four CB Plan participants with 0.5% or higher EBARs Four 40% of eight participant 2. Easy pass on Normal EBARs One to one rate group coverage: 100% ratio! 3. We pass combined plan deduction limit Total coverage payroll = $830,000 (omit Associates pay) 6% of $830,000 = $49,800 Our PS total is $49,100 60 30
Determination of MVAR Age 50 HCE CB pay credit of $136,000 Convert to 50% joint and survivor annuity: divide by APR using plan rates (5%, 2015 417(e) table) at age 50 = 200.3952 50% J&S immediate benefit = $136,000 / 200.3952 = $679 Take PV at testing assumptions = 129.0372 * $679 = $87,572 Increase to age 62 = $87,572 * 1.085 (62 50) = $233,090 Convert to age 62 annuity = $233,090 / 101.7180 = $2,292 Most valuable accrual rate = $2,292 * 12 / $265,000 = 10.4% Add profit sharing accrual rate = 10.4% + 1.8% = 12.1% 61 Determination of Gateway Age 50 HCE CB pay credit of $136,000 and $14,800 PS Take present value of NAR benefit, using testing assumptions: $1,390 * 101.7180 / 1.085 (62 50) = $53,120 Add PS contribution: $53,120 + $14,800 = $67,920 Gateway = $67,920 / $265,000 = 25.6% Note: PV of $136,000 credit is $53,120 >> 61% discount! 62 31
Case Study Category Gateway ABPT Total MVAR Partner 25.6% 10.2% 12.1% Partner 10.2% 12.1% 12.1% Associate 1 10.8% Associate 2 15.0% Staff 1 6.5% 2.6% 1.4% Staff 2 6.5% 5.9% 3.1% Staff 3 7.0% 13.9% 8.6% Staff 4 6.8% 20.6% 12.4% 63 Case Study 1. We pass Gateway Highest HCE aggregate allocation: 25.6% All benefiting non HCEs must be at 6.0% Since non HCEs all at 6.5% profit sharing, Pass! 2. Average benefits percentage test passes HCE average is 12.0% non HCE average is 10.8% ABPT ratio = 90% >>> Pass! (threshold = 70%) 64 32
Case Study 3. We pass General Test Only one rate group (12.1% and higher) HCEs in rate group: 2 out of 4 >> 50% coverage non HCEs in rate group: 1 out of 4 >> 25% coverage Ratio percentage = 25% 50% = 50% Passing threshold = 45% >> Pass! If there were no Associates, Fail! Ratio = 25%; Passing threshold = 40.5% 65 1.415(b) 1(a)(3): 415 Limits Plan provisions must preclude the possibility that any annual benefit exceeding these limitations will be accrued, distributed, or otherwise payable in any optional form of benefit Must design CB Plan to meet 415: To accrued benefit stated as annuity at NRA At annuity starting date Projected benefit used in funding calculations 66 33
Example: 415 Limits Age 55 First year of service in 2014 Age 62 NRA Interest crediting rate: 5.5% Annuity conversion: 5.0% 2015 417(e) Mortality 2015 cash balance formula credit: $200,000 67 Example: 415 Limits 1. Limit Accrued Benefit as annuity: $21,000 Convert to current account $21,000 * a 62 / 1.055^(62 55) = $188,386 Must the formula credit of $200,000 be reduced? EA Gray Book 2014 29: Section 415 requires the plan to limit the accrued benefit and optional forms of benefit, not the hypothetical account balance. 68 34
Example: (continued) 415 Limits 2. Limit benefit at annuity starting date $21,000, reduced by lesser of 415 and Plan factors 415: (a 62 / 1.05^(62 55) / a 55 ) = 0.621 Plan: Age 55 benefit: a 62 / 1.055^(62 55) / a 55 = 0.601 Plan assumptions apply (because of 5.5%) Annuity limit = $21,000 * 0.601 = $12,617 69 Example: (continued) 415 Limits 2. Limit benefit at annuity starting date (continued) Convert immediate annuity limit to account value using 415 lump sum assumptions Either small employer, or 417(e) rates are too low to apply, so use 5.5% $12,617 * a 55 (5.5%) = $178,575 Current distribution cannot exceed $178,575 Current formula balance is still $200,000 70 35
Questions? 71 36