A Practical Guide for Setting Your New Cash Balance Plan’s Interest Crediting Rate

The popularity of cash balance plans for small businesses continues to grow and as we consult with prospective clients and their investment advisors, the second biggest decision after deciding to go forward with adopting the new plan always seems to be the interest crediting methodology. This is an important discussion that should involve the plan sponsor, the investment advisor and the actuary.

But Why Cash Balance Plans?

First everyone needs to understand the reason for the cash balance plan and its fundamental difference from the profit sharing 401(k) plan. The cash balance plan is a tax deferral plan that allows business owners to set aside large amounts for their retirement on a tax favored basis. The majority of the benefit comes from principal (contributions) and not from investment experience, and those contributions are limited based on a maximum projected accumulation using a statutorily mandated interest assumption. That is, cash balance plans are limited on the upside so there is no advantage to incurring risk for higher returns other than to reduce future tax deductible contributions. It is the profit sharing 401(k) plan that is the asset accumulation plan, where the majority of the final benefit is designed to come from the investment experience.

Next, business owners should understand that they assume the investment risk. For example, if the plan is required to provide interest of 3% and assets return only 1%, then they are on the hook for the difference. This isn’t an annual dollar for dollar determination as underfunding is amortized over multiple years, but that’s a discussion for another time.

Plan Sponsors Summary

So plan sponsors want to know what interest credit methodology they should use and then investment managers, who are otherwise experienced in developing 401(k) fund lineups, want to know how to invest the portfolio. Here’s a helpful recap: owner benefits are limited on the upside and owner has liability on the downside – so they probably don’t want to guarantee a high interest credit rate and/or invest primarily in equities.

I could use all this space and still not exhaust the possible interest crediting choices post-PPA, but the practical and most popular choices in my opinion are various term Treasury related benchmarks, fixed rates, and the actual rate of return on plan assets. Each has its advantages and disadvantages and statutory requirements and limitations.

Plan sponsors and their investment advisers are becoming more attracted to the actual rate of return on plan assets (the brave new world?), sponsors because it limits their downside liability and advisers because they don’t have a specific benchmark to meet. However, the plan must guarantee the cumulative principal (contributions) over a participant’s career so the downside risk to the sponsor is not completely eliminated. Also, using the actual rate of return on plan assets creates some unique compliance and administrative complexities and challenges.

Summary

There is no one correct answer here, but the key considerations are the expected duration of the plan, including the expected retirement date(s) of the principal(s), the risk tolerance of the stakeholders, and the impact on various statutory requirements and limitations, including 415 limits, minimum participation standards and nondiscrimination testing – and having an actuary who understands these issues and who can explain them to the plan sponsor and investment adviser at the onset is critical to the ultimate decision on an interest crediting methodology that will satisfy the plan sponsor’s objectives.