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How They Work

The benefit in a cash balance pension is defined as a notional account. This account is created by crediting a participant with hypothetical contributions to his or her account. Cash Balance Plans generally have two types of credits that create the notional account: pay (or service) credits and interest credits.

Each year, a participant in the plan may earn pay (or service) credits based on his or her period of employment. The pay (or service) credit is conceptually similar to a contribution to an individual account in a defined contribution plan. This credit is generally based on pay during the year, but could also be defined as a flat dollar amount or an amount that is actuarially determined to meet the requirements of IRC §401(a)(26) (see example below).

The amount of the pay credit can be defined based on factors such as age, service, or points (age plus service) or any other non-discriminatory basis. Though it is not all that common, a pay credit can also be integrated with Social Security, providing a larger accrual on pay that is above the Social Security Wage Base (or some other variant of the SSWB).

Pay credits, or Cash Balance Credits, need to be designed so that they do not violate other rules influencing plan design, such as the accrual rules of the IRC §411(b) and the myriad of nondiscrimination tests under IRC §401(a)(4).

The accrual rules were designed by the IRS and DOL to ensure that the benefit accrual by a participant in later years cannot be excessive relative to the accrual in earlier years. In other words, the benefit accruals may not be excessively backloaded. There are three general rules to determine whether a benefit is too backloaded: [ERISA §§ 204(b)(1)(A), (B), & (C); I.R.C. §§ 411(b)(1)(A), (B), (C)]

  1. 3% rule. A participant's accrued benefit upon separation from service must not be less than 3 percent of the normal retirement benefit the participant would receive, if the participant began participating at the earliest entry date possible under the plan and worked continuously until the earlier of age 65 or normal retirement age, multiplied by the number of years the participant would have participated in the plan at that point (but not more than 331/3 years). [I.R.C. § 411(b)(1)(A)]
  2. 1331/3 % rule. The annual rate at which a participant can accrue a normal retirement benefit (typically measured as the change in the normal retirement benefit as a percentage of participant compensation, but possibly measured as the change in the dollar amount of the normal retirement benefit, as permitted by IRS Revenue Ruling 2008-7) for any year must not be more than 1331/3 % of the annual rate at which the participant can accrue a normal retirement benefit in any preceding year. [I.R.C. § 411(b)(1)(B)]
  3. Fractional rule. The accrued benefit at separation from service must not be less than a fraction of the accrued benefit at normal retirement age, determined as if the participant had earned compensation until normal retirement age and treating the participant as having attained normal retirement age on the date the fractional rule is being tested, but taking into account no more than 10 years of service immediately prior to separation from service. The fraction for the test has the number of years of participation until separation from service as the numerator and the number of years of participation as if the participant continued in active service until normal retirement age as the denominator. [I.R.C. § 411(b)(1)(C)]

The basic purpose of coverage and nondiscrimination testing [IRC §401(a)(4) et al] is to ensure that a tax-qualified plan, whether a defined contribution plan or a cash balance plan (or a defined benefit plan other than a cash balance plan), does not significantly discriminate in favor of higher compensated employees relative to lower compensated employees. Basically, the notion is that since the plan has a tax-favored status, the plan should not cover too many higher paid employees and too few lower paid employees, nor should the plan provide too much greater benefits to higher paid employees than to lower paid employees. The coverage and nondiscrimination tests define what is meant by too many and too much.

The employees covered by benefits under a tax-qualified plan cannot be significantly skewed in favor of highly compensated employees. Coverage testing [IRC § 410(b)] is intended to ensure that plan coverage does not significantly discriminate in favor of Highly Compensated Employees (HCEs). In essence, coverage testing compares the number of Non-highly Compensated Employees (NHCEs) benefiting under a plan relative to the total number of NHCEs of an employer (controlled or affiliated service group) against the number of HCEs benefiting under the plan relative to the total umber of HCEs of the employer.

Below is an example of how a very simple Cash Balance Plan works:

A cash balance plan may provide for an annual credit of 6 percent of pay made at the end of each year and credit interest at a rate of 4.5 percent. If Alexa is a new participant to a cash balance plan at the start of the year, with pay of $100,000, her annual pay credit would be $6,000 (6 percent of $100,000). At the end of her first year of participation, her benefit would be defined as a hypothetical account balance of $6,000. During the second year, Alexa would accrue both interest credits on her account of $270 (4.5 percent interest credit applied to the $6,000 account balance at the end of the first year) as well as another pay credit of $6,000 (6 percent of his pay of $100,000). In total, her hypothetical account balance at the end of her second year of participation would be $12,470

Account Activity Alexa's Cash Balance Account
Account balance at the start of year 1
$0
Interest credit for year 1 (4.5% of $0)
$0
Pay credit for year 1 (6% of $100,000)
$6,000
Account balance at the end of year 1
$6,000
Interest credit for year 2 (4.5% of $6,000)
$270
Pay credit for year 2 (6% of $100,000)
$6,000
Account balance at the end of year 2
$12,270

Alexa would see a “hypothetical balance” of $12,270 on her benefit statement at the end of year 2.

Below is an example of what can be done with a very small group using a combination of a Cash Balance Plan and a Profit Sharing 401(k) combination. The combination of a Cash Balance Plan and Profit Sharing 401(k) Plan is used quite extensively for plans that want to maximize benefits to a select group of employees but in order to do so must cover a certain number of employees to meet coverage and nondiscrimination test.

Group Demographics:

Principal 1 Age 59 $230,000/yr
Principal 2 Age 61 $100,000/yr
EE 1 Age 44 $61,000/yr
EE 2 Age 33 $32,000/yr
EE 3 Age 30 $35,000/yr
EE 4 Age 31 $38,000/yr

The goal for this group is to maximize benefits for Principal 1 and 2 while staying within a pre-set limit of $75,000 for Principal 2 and to minimize benefits for EE1 through 4 while meeting coverage and nondiscrimination tests.

For this group we have the following results:

PARTICIPANT CB CONTRIB. P/S CONTRIB. 401(K) DEFERRAL TOTAL %OF TOTAL
Principal 1$175,000$9,200$16,500$200,70063.66%
Principal 2$75,000$7,500$16,500$99,00031.41%
EE 1$1,968$4,621$0$6,5892.10%
EE 2$337$2,435$0$2,7720.88%
EE 3$306$2,590$0$2,8960.92%
EE 4$357$2,675$0$3,0321.03%

This plan used a 7.5% Gateway for Cross-Testing purposes, used an CB (Hypothetical) contribution for EE’s 1-4 that is the actuarial equivalent of a 0.5% of compensation accrual for IRC §401(a)(26) purposes and provides an average accrual rate for the NHCEs of 10.9325% vs. 12.4400 for the HCEs. The Average Benefits Test is passed at 87.88%.

Now go to: Cash Balance Plans-How they REALLY work !

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