Cash Balance Vs. Defined Benefit Plans

Listed below are some of the reasons why cash balance plans are generally preferred, as a plan design, over a traditional defined benefit plan. Of course, each situation depends on its own facts and circumstances and the objectives and needs of the client. We believe that larger firms with multiple owners/partners need a plan design that can meet the individual needs of each shareholder/partner without exposing them to cross subsidization issues or greater liabilities associated with traditional DB plans.

Administration Costs: This used to be the biggest advantage for traditional defined benefit plans when compared to cash balance plans. Until 2015, the IRS does not allow any cash balance plans to use a volume submitter or prototype plan document. Therefore, all cash balance plans were considered "Individually Designed" and need to be restated and submitted to the IRS for approval once every 5 years instead of once every 6 years.  Now there is really no difference in administration cost for the plan document between a cash balance plan and a defined benefit plan.  

The other reason cash balance plans can have higher costs of administration than defined benefit plans is because they generally require nondiscrimination testing every year to prove to the IRS that the non-highly compensated employees (NHCEs) are getting a "fair" amount of benefit from the plan or plans. Most traditional defined benefit plans use a safe harbor benefit formula which is less flexible and usually gives larger contributions to employees but doesn't require annual nondiscrimination testing.

Employee Costs: Since most traditional defined benefit plans use a safe harbor formula to avoid nondiscrimination testing, they usually require larger amounts of money to go to the employees. A safe harbor formula means that each participant is bound by the same formula as any other participant. Common examples of safe harbor DB formulas are 10% times high 3 year average compensation times years of service up to 10 and 250% of high 3 year average compensation reduced by years of service less than 25.

Contrast the above formulas with the following common cash balance plan formulas:

1. Owners get an annual allocation of $150,000 in a cash balance plan plus $32,500 in a profit sharing plan. Non-owners each receive 2% of pay in a cash balance plan and 7% of pay in a profit sharing plan.
    
2. Owners get an annual allocation of 60% of pay in a cash balance plan plus $32,500 in a profit sharing plan. Non-owners each receive $750 in a cash balance plan and 7% of pay in a profit sharing plan.

Both DB and CB plans can provide the same maximum contributions and if no safe harbor formula is used, both can provide them with the same employee costs. But to save money on the annual administration a safe harbor formula must be used. The right choice depends on demographics and the other needs of the plan sponsor.

Age Sensitivity: The first demographic to consider is the age of the owners compared to the employees. All of these plan designs are more tax effective when owners are at least 10 years older or more than the youngest employees, and the bigger the disparity, the better. The big difference lies in the cost of the oldest employees. In a cash balance plan, the oldest employees get the same benefit as the youngest employees, generally a percentage of pay or a flat dollar amount. In a safe harbor traditional defined benefit plan, the oldest employees cost far more than the youngest employees and don't increase the amount the owners can put away for themselves.

Compensation: The next demographic to consider is how each type of plan deals with compensation increases. In a cash balance plan, the hypothetical allocations generally increase as compensation increases. However, it only affects the current year contribution. In a traditional defined benefit plan the benefit is usually based on a high 3 or 5 year average of compensation. And that average is multiplied by all years of service so a few good years for the employees can really increase the cost of the plan for every year. Again, this is compounding the problem of older employees who are generally making more towards the end of their careers. A cash balance plan is what is commonly known as a "career average pay" plan since instead of just using the highest few years of compensation it uses the average of all years including the lowest ones.

Vesting: The final demographic to consider is how long employees generally work for the company. Cash balance plans require 100% vesting after 3 years which is also allowed in traditional defined benefit plans, but traditional DB plans can also have a vesting schedule that provides 0% for the first year, 20% for the second year, 40% for the third year, and so on until 100% in the sixth year. So if the plan sponsor has a lot of turnover in years 3 through 5 a traditional DB plan might be able to defray some of the employee cost through vesting.

Interest rate sensitivity: This is the most important section to understand in this entire document. It's the main reason why corporations have sought to convert existing DB plans to CB plans over the last 25 years and will probably cause all but the smallest traditional DB plans to be extinct in the next 25 years. The value of the liabilities in a traditional defined benefit plan fluctuates dramatically with interest rates whereas the liabilities in a cash balance plan only move slightly when interest rates change.

Let's say that as of January 1, 2009 a traditional defined benefit plan and cash balance plan with the exact same demographics both have $1 million dollars in assets and liabilities so the plan is perfectly funded if it terminated immediately. Let's also say that the interest rate for valuing liabilities if 5% for 2009, 6% for 2010 and 4% for 2011 and nothing else changes during those 3 years. Finally, we'll assume that both plans earn 5% on assets each year.

Both plans will have assets and liabilities of $1.05 million at the end of 2009, but on the first day of 2010 the defined benefit plan liabilities will change overnight to be roughly $0.87 million. This leaves the plan in an overfunded status and will reduce the 2010 contribution. The cash balance plan still has assets and liabilities of $1.05 million.

At the end of 2010 both plans have assets of about $1.10 million. The DB plan has liabilities of $0.92 million and the cash balance plan has liabilities of $1.11 million. At the start of 2011 the interest rate has now dropped to 4%. The cash balance plan is still $0.01 million underfunded whereas the defined benefit plan now has liabilities of about $1.25 million and is $0.15 million underfunded.

The key thing to notice from the above example is that cash balance plans are relatively predictable while traditional defined benefit plans are unpredictable because the cost of them depend so heavily on interest rates that fluctuate from year to year. No asset manager can predict how interest rates will change from year to year, and even if they could, they couldn't achieve the returns necessary to keep the contributions from fluctuating. When interest rates went up, the fund would have to lose money to avoid being underfunded, and when interest rates went down the fund would have to have huge returns. Doesn't that seem backwards?

Take a historical look at the news stories about traditional defined benefit plans being underfunded and you will notice that they always happen in periods of low interest rates. This isn't a coincidence. It is due to the inverse relationship between interest rates and liabilities and the only way to get rid of that risk is to have a cash balance plan instead of a traditional defined benefit plan.

Asset/Liability Matching: Any advisor who has worked with defined benefit or cash balance plans will tell you that the key to keeping the plan sponsor happy is to make sure they have predictable contributions and therefore tax deductions every year. The only way to do that is for the advisor to work with the actuary to make sure the assets in the trust are increasing about as fast as the liabilities of the plan. As we discussed above this is almost impossible to do in a traditional defined benefit plan because the interest rates are required by the government and set by the free market. A cash balance plan mitigates these risks but does not remove them entirely. The most commonly used cash balance crediting rate is the yield on the 30 year treasury bond. It is nice because it is the same for every participant regardless of age, but it generally does change once per year. It helps to keep pace with inflation, but if the assets are invested aggressively, it can cause some big problems if the assets overperform or underperform. Traditional defined benefit plans are required to use "417(e) segment rates" which are defined by the government and depend on age and corporate bond yields in the marketplace. They also change every year and can be difficult to understand for participants and plan sponsors.

Ease of Understanding: In a traditional DB plan, the benefit is defined at the normal retirement age and is guaranteed by the plan sponsor. In a cash balance plan, the benefit is defined as the actuarial equivalent of an accumulation of contributions and earnings and that amount is guaranteed by the plan sponsor. If the participants are looking for a replacement of pay at retirement age, a traditional DB plan may be easier to understand, but we believe that most participants are looking for a lump sum whenever they are no longer employed by the company. In that case, a CB plan is easier to understand. Participants in a cash balance plan get an annual statement showing exactly what their balance in the plan is and how it changed from last year to this year. To them it looks just like a profit sharing plan with a guaranteed rate of return.

Flexibility: The final point I'd like to discuss is basically a repeat of my 3 points above, but it really helps from the plan design stage on through the termination of the plan. A lot of times a traditional defined benefit plan looks great in the design stage because the employees are young and the owner is going to work another 10 years. But as the demographics change over the years, it's often hard for plan sponsors and advisors to understand the effects those changes have on the plan. In a cash balance plan, we know the value of the assets and the liabilities and how much of each belong to each person. So it's easier to take on partners, have partners retire, and change contribution levels as the needs of the plan sponsor change. Cash balance plans are still not defined contribution plans so some planning is required, but as long as you keep in touch with the actuary as things change, there are usually steps that can be taken to make sure the plan sponsor's goals are met. Changes will almost always involve a plan amendment and a notification to the employees, but those are relatively simple things to do. Traditional defined benefit plans can also be amended, but due to the interest rate and demographic risks discussed above it is more difficult to exactly meet the goals of the plan sponsor.