By Patty Kujawa
Jan. 23, 2015
Traditional pension plans seem headed for extinction, but a different kind of defined benefit plan has been given new life thanks to recent rules from the Internal Revenue Service outlining specific ways to design cash balance plans.
These plans have been around for decades, but even after a 2006 law tried to clarify rules, plan sponsors have been looking for more. Cash balance — also known as hybrid plans — use different interest rates to value benefits. Four years ago, the federal government built on the 2006 law with preliminary rules but didn’t provide the confidence many plan sponsors needed to go ahead.
Specifically, the new rules released in September say plan sponsors can use the actual rate of return they get on the plan’s investments. The guidelines, which go into effect in January 2016, also boost other allowable rates of return and say plan sponsors can use different formulas to suit specific groups of employees within their workforce. Lastly, the IRS proposed a rule that would allow plan sponsors to make corrections to their plans, within a certain time frame, without violating IRS rules.
For years, “design got ahead of guidance, so this became a bit problematic,” leaving sponsors wondering whether their plans passed IRS tests, said Brian Donohue, a partner at Chicago-based financial consultant October Three Consulting. The new guidelines are “the fulfillment of a vision created decades ago.”
While traditional defined benefit plans are closing out every year, cash balance plans have held steady for Fortune 500 companies, according to annual research from Towers Watson. Traditional pension plans decreased 4 percent to 118 in 2013 from 123 in 2012. Hybrid plans held firm over that time period with 84 plans in service.
Cash balance is not typical because while all the assets are invested collectively, individual benefits are defined by an account balance, just like a 401(k). Final payout can come as a lump sum or an annuity.
The new rules give more flexibility, allowing plan sponsors to choose from an extended list of rates to suit their plan and its participants.
For example, plan sponsors can create investment subsets that mirror 401(k) target date funds, so longer-serving employees are tied to a more conservative rate of return, while younger employees are connected to more aggressive investment returns. Certain requirements need to be, but it helps plan sponsors better match the interest credit for specific groups, instead of using a one-size-fits-all rate.
“Being able to provide benefits with no risk to employers is the single biggest thing in these regulations,” said Jack Abraham, principal at PricewaterhouseCoopers in Chicago.
Abraham noted that cash balance plans can provide professionally managed investments with low expenses — unlike many 401(k) plans. Plus, employees typically make mistakes with 401(k) accounts when left choose investments on their own.
“There’s a lot of money in these 401(k) plans that is not invested efficiently to meet the objectives” for the participant, Abraham said.
Dr. Robert Master, retirement plan committee chairman for the Palo Alto Foundation Medical Group, said he was “mildly shocked” when he first looked at employee 401(k) account balances in 2000. The group decided to add a cash balance plan to help plan participants boost their retirement accounts.
On the flip side, the IRS places limits on how much can be contributed to a 401(k) plan. Adding a cash balance plan can help power up retirement savings, Master said.
“It’s sort of a catch-up retirement plan. It’s a nice complement,” he said.
In the smaller business market, hybrid or cash balance plans are booming, and the flexibility and clarity provided by the new rules will only increase plan sponsor interest and eventual use, said Don Kravitz, president of Los Angeles-based retirement management firm Kravitz Inc. A June study by his company showed a 22 percent increase in cash balance plans in 2014. Nearly 90 percent of cash balance plan growth came from companies with fewer than 100 workers, and nearly all of the companies surveyed combine a cash balance plan with one or more defined contribution plans.
“The 401(k) plan was never meant to be the mainstay of retirement,” Kravitz said. “Adding cash balance enhances the retirement benefit and takes up the slack for some of 401(k)’s weaknesses.”
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