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How They Really Work

Let’s review our example from the previous page:

Principal 1 Age 59 $230,000/yrHypothetical Contribution $175,000
Principal 2 Age 61 $100,000/yrHypothetical Contribution $75,000
EE 1 Age 44 $61,000/yrHypothetical Contribution $1,968
EE 2 Age 33 $32,000/yrHypothetical Contribution $337
EE 3 Age 30 $35,000/yrHypothetical Contribution $306
EE 4 Age 31 $38,000/yrHypothetical Contribution $357

One of the most frustrating aspects of communicating a Cash Balance Plan to clients is explaining why the total of the “Hypothetical Contributions” and the required contribution under PPA rarely, if ever, match.

Using our example group, Principal 1 receives a Hypothetical Contribution of $175,000/yr and at age 65 she will have a distribution from the plan of $1,190,335 using the plan’s 5.00% interest rate.

Our example shows a total contribution of $253,968 to our “Hypothetical Accounts”, lets compare that to the actual funding as of January 1, 2008

Participant Hypothetical Contribution Target Normal Cost
Principal 1
Principal 2
EE 1
EE 2
EE 3
EE 4

So what happened? Under PPA Funding Rules, segmented interest rates must be used for valuation purposes and the segmented rates for this valuation were: 1st Segment, 5.31%, 2nd Segment, 5.92% and the 3rd Segment, 6.43%. Principal 1 effectively had her retirement benefit accrual converted to a monthly annuity at her normal retirement age for funding purposes and discounted back to the valuation date using the segmented interest rates. That process generated the Target Normal Cost. Our hypothetical account assumed an accumulation rate of 5.00% until retirement for the current and all future contributions.

In general, two key features of cash balance plans significantly affect the impact of PPA rules on defined benefit funding:

  1. Cash balance benefits are often paid out in lump-sum single distributions; and
  2. Cash balance benefits themselves are often linked to bond yields.

Impact of lump-sum distribution prevalence

The prevalence and high usage of lump-sum distribution options in cash balance plans mean that benefits are paid out sooner than they would be if only annuity payments were available. This has three impacts on the plan's funding requirements:

  1. The shortening of the time until the benefit is paid out reduces the impact of any change in the interest rate used to calculate the present value of the benefit. This has become more and more important as there has been a trend toward more market-based assumptions. Although the basic ERISA rules used a long-term assumption for the interest rate, both the liability measure introduced in the mid-1980s (the current liability) that was used to determine any additional funding charge and the funding target that is used under the new PPA rules are determined using an interest rate that is updated annually.
  2. The shorter time until benefits are paid out means that when liabilities under the PPA are measured using a yield curve, more of the benefit will be calculated based on the shorter end of the yield curve and thus, will be calculated using lower interest rates. This may mean that the switch to the PPA rules could have a larger impact on cash balance plans. Although, as stated previously, a relatively flat yield curve environment may offset most of this issue in the short term, it is something worth looking at more closely in multi-year budget estimates.
  3. Several of the funding requirement calculations look at how well the plan is funded on a percentage basis based on the ratio of the plan's assets to the plan's liabilities. Lump-sum payments can quickly change the funded ratio even when the lump sums are anticipated in the valuation assumptions. For example, if a plan has $600,000 of assets and $750,000 of liabilities, it would be 80 percent funded. However, if $100,000 is paid out in lump sums, then the plan would have $500,000 of assets and $650,000 of liabilities, and be 77 percent funded. The impact could be even greater if the plan is not assuming benefits will be paid in a lump sum and experiences an actuarial loss because the assets paid out are greater than the reduction in liability. This dynamic can cause additional volatility for cash balance plans, especially during downturns in the plan sponsor's business when there may be workforce reductions. For example, after a plant closing, many people will be eligible to collect lump sums, and may need them much earlier than originally assumed in the valuation. This can have a significant impact on the plan's funded status and funding requirements just when the plan sponsor can least afford it.

Impact of interest crediting rate

A cash balance benefit increases each year with interest credits. These credits are usually based on the yield on Treasury bonds. Therefore, as bond yields drop, the benefit is lower than it would be if the yields did not drop.

In a valuation of the plan, an assumed future interest crediting rate is set every year. Although this historically has been a reasonably stable assumption, the trend, which is reinforced with the PPA, has been to base funding on more market-based assumptions. One might expect the assumed interest crediting rate to be reviewed more frequently, potentially on an annual basis. This will have the effect of significantly lowering projected benefit amounts as current bond yields drop.

Because the PPA rules will require the funding requirements to be based on a yield curve developed from the yields on corporate bonds, [I.R.C. § 430(h)(2)(D)] the funding requirement rules will work against the calculation described above. In other words, as bond yields drop, the funding requirement calculations of the present value of the benefit will increase while the current assumed future interest crediting rate for the plan decreases --lowering projected benefit amounts. Since these two calculations work in opposite directions, they will help dampen cost volatility for cash balance plans under the PPA funding rules due to any bond rate changes.

Since the interest crediting rate for most cash balance plans is currently based on long-term Treasury bonds, other factors should be considered when looking at the extent of the volatility remaining for cash balance plans:

  1. If the interest crediting rate is switched to a market based interest rate as allowed under the PPA, [PPA § 701(a)(1), amending ERISA § 204(b)(5)(B)(i)(III)] potentially following equity returns, the volatility for the plan will likely increase instead of providing the dampening effect described above; and
  2. When the yield-curve is flat, the yield used to discount payments to be made in the near future is not that different from the yield on long-term bonds. If this curve becomes steeper with yields increasing as the timeframes lengthen, then a mismatch will arise between using a long-term rate for interest crediting and a short-term (or even mid-term) rate for discounting the benefit used for the PPA funding calculations. This would also lessen the impact of this volatility dampening.
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