The Internal Revenue Service (IRS) has published a final rule covering tax-qualified cash balance (hybrid) pension plans, providing guidance on the key issue of “market rate of return.” Sponsors of hybrid plans have waited for four years for this guidance since the agency delayed the effective date of an October 2010 final rule following practitioners’ concerns that the IRS had incorrectly interpreted the statutory definition. In general, the final rule applies to plan years that begin on or after January 1, 2016.
The IRS also published a companion proposed rule to facilitate the transition for plan sponsors to adopt requirements, allowing for an election to apply the proposed rule to amendments adopted earlier than January 1, 2016. The IRS seeks comments on the proposal by December 18, 2014.
This Client Action Bulletin discusses final and proposed rules for hybrid pension plans.
On September 19, 2014, the Internal Revenue Service (IRS) published final regulations providing guidance on hybrid pension plans that includes some items of interest to multiemployer pension plan trustees. Although mainly focused on cash balance and pension equity plans, the guidance includes provisions related to variable annuity pension plans (VAPPs), which have been drawing attention among trustees who believe there is enormous value in the defined benefit system. Some of the more onerous provisions needed to satisfy hybrid plan rules are now explicitly removed for VAPPs, and trustees adopting VAPPs have been given more flexibility in plan design. This Multiemployer Alert offers some perspective on the final regulations.
Employers and owners continually look at different strategies to defer tax on income, provide benefits to key employees, and boost their retirement savings. As Bart Pushaw noted in a recent blog post, cash balance plans have the potential to provide for solid retirement security and shelter greater income from taxation to increase retirement wealth. The big question for employers remains how to know if adding a cash balance plan is right for them.
Advantages of a cash balance plan for employers:
• They offer the potential for larger tax-deferred contributions than permitted under current defined contribution (DC) limits for owners or key employees.
• Tiered benefit levels are attractive to partnerships and professional services.
• Account balances are easy to understand for participants when compared to traditional defined benefit (DB) plans.
• Cash balance plans are generally less volatile and less expensive than traditional DB plans.
• They can provide greater funding flexibility than DC plans.
Disadvantages of a cash balance plan for employers:
• They require actuarial services to determine funding levels.
• Plan funding levels may restrict lump sum payments.
• Typically, the employer bears the investment risk.
• Cash balance plans require Pension Benefit Guaranty Corporation (PBGC) premiums.
• Typically, plans are individually designed so plan documents are more expensive than prototype documents.
Candidates for a cash balance plan:
• Employers that want contributions in excess of the limits allowed under DC plans for owners, partners, or key employees
• Employers that have the resources to make the required contributions
• Employers that generally are not affected by economic volatility
• Employers with older key employees and younger staff
• Employers who have a generous 401(k)/profit sharing plan for staff
If you are an employer who fits the candidate criteria above, and believe that the advantages of a cash balance plan may outweigh the disadvantages, then now might be the right time to investigate further.
New opportunities for owners and key staff to save for retirement on a tax-favored basis bring with them popularity and value. For this reason, a cash balance plan may be worth considering.
Owners and professionals
Cash balance plans have the potential to substantially provide for solid retirement security and shelter greater income from taxation to increase retirement wealth. These programs will not fit each and every owner’s situation, but a range of programs has been used to meet significant needs and concerns.
The typical case is one where the organization already contributes to an all-employee profit sharing or 401(k) plan. Oftentimes the program can be modified with a cash balance plan, extending it for owners who can then annually contribute amounts in excess of the profit-sharing-only maximum of $51,000. Additional annual tax-deferring contributions can range up toward $250,000.
The details of the programs can be worked out with advisors to custom fit most financial situations.
Executives at large corporations
The opportunities mentioned above are even better for corporate executives wishing to enhance their retirement wealth and financial security as well. Large corporations often sponsor nonqualified Supplemental Executive Retirements Plans (SERPs) for key management. Cash balance programs allow vastly stronger security arrangements, moving these benefits from the nonqualified arena to qualified status.
Adopting a cash balance plan could further strengthen the retirement promise, allowing monies to be put into trust for the sole benefit of the executives. No insurance contracts or long-term commitment would be needed. Investments would be controlled by management and allow access to institutional pricing of funds.
Again, every situation is different, but for executives, owners, and professionals the incorporation of a cash balance plan may be a great asset in the ongoing effort to secure a well-funded retirement.
Since the global financial crisis of 2008, the U.S. population has struggled to recover and/or grow retirement savings. Employers providing defined benefit (DB) plans face overwhelming funding expenses, driven by increased life expectancy, stock market fluctuations, and low interest rates. The latter two factors, resulting from the severe recession and unpredictable economic environment experienced since then, have also severely impacted employers’ ability to fund defined contribution (DC) plans.
Kelly Greene, of the Wall Street Journal, recently discussed this issue and cited the Employee Benefit Research Institute’s latest retirement confidence survey. This study states that the percentage of U.S. workers demonstrating little to no confidence regarding the adequacy of their retirement funds is at an all-time high. Only 13% of workers surveyed report being very confident they have enough saved for retirement and 38% report some confidence in their preparedness. Five years ago, those two figures totaled approximately 70% of workers surveyed. Employers and employees need to work together to remedy this situation. Depending on the design of the plan, the answer could be a defined benefit plan, a defined contribution plan, or a strategic combination of the two.
Possible solutions can be categorized from basic to more radical. One proposal is to convert traditional pension plans to cash balance plans rather than merely freezing them. However, the advantage of this strategy is still diminished by the significant issue of longer life expectancies. Better stock performance and, hopefully, within the next few years, better interest rates will relieve some pressure on benefit obligation expenses. Discussing the results of the Milliman Pension Funding Study released March 25, John Ehrhardt stated that “pension funding status will continue to be tied to interest rates” and “until interest rates move favorably, the pension funding deficit is likely to endure.”
A middle ground solution might be to introduce a profit sharing element to the retirement plan package. There are a few drawbacks to a profit sharing plan, mostly increased administration, but the positives in many cases outweigh the negatives. Profit sharing plans are discretionary and, theoretically, self-funding. These plans tie employee incentives to company growth and form a strong partnership between employers and their employees. With the stock market showing some improvement and the economy demonstrating strengths (Wall Street Journal), companies could, over time, see an upswing in business. Plan sponsors can seize that opportunity and distribute some of those profits to employees, utilizing performance accountability measurements. Other, straightforward strategies include implementing auto enrollment processes and increasing employee retirement plan education. Employees need guidance. They are not professional investors. Companies can meet the challenges of today’s retirement savings environment and take pride in assisting their employees in this venture.
In Notice 2011-85, the IRS announced a delay of the effective or applicability dates for the interest crediting rules affecting cash balance and similar hybrid defined benefit (DB) plans. These final and proposed regulations, both published in October 2010, include rules to establish a regulatory “market rate of return” and have been roundly criticized by sponsors of cash balance plans and their advisors.
Notice 2011-85 states that, for these defined benefit plans:
- The interest crediting rate rules under the October 2010 proposed regulation (IRC section 411[b]) will be effective no earlier than January 1, 2013, for plan years beginning on or after the date the yet-to-be-issued final rule will specify.
- The current application date of the market rate of return rules under the October 2010 final regulation that are effective January 1, 2012, are similarly postponed.
- The deadline to adopt interim or discretionary amendments relating to vesting and other special rules (IRC sections 411[a] in general and 411[b]) is extended to the last day of the plan year for which the yet-to-be issued final rule will apply.
- The IRS expects to grant relief from the anti-cutback requirements (IRC section 411[d]) if an amendment reducing or eliminating protected benefits is timely adopted and the benefit reduction or elimination is only of an amount necessary for the plan to satisfy the age discrimination and market rate of return rules (IRC section 411[b]).