Secure 2.0 Act May Breathe New Life Into Cash Balance Plans

Cash balance plans may now be a viable option for a wider range of employers.

The Setting Every Community Up for Retirement Enhancement (Secure) 2.0 Act made significant changes that affect all clients’ retirement income planning strategies. One of the lesser-discussed changes involves defined benefit cash balance plans.

Under prior law, cash balance plans were complicated and difficult to administer because no variability was permitted in the way pay credits were allocated to employees — and it could often be difficult for employers to pass so-called “backloading tests” that were designed to prevent discrimination in favor of employees with longer service records.

Secure 2.0 Act has provided employers interested in cash balance plans with the certainty of designing these plans without fear of disqualification — and offered many small business clients a much more alluring and powerful employee benefit option to attract and retain top talent.

Secure 2.0 Act Changes

Under the Secure 2.0 Act, cash balance plan sponsors are now permitted to assume an interest rate that is “reasonable,” as long as the assumed interest rate does not exceed 6%.

Cash balance plans cannot “backload” their credits, so that older employees with longer service records enjoy more significant benefits than employees with fewer years of service. One test requires that the plan’s annual pay credit be less than 33.3% of the prior year’s pay credit.

Higher interest credits generally make it easier for plans to pass these “backloading tests.” The 6% cap is designed to prevent employers from assuming unreasonably high interest rates to pass the backloading test. Under prior law, the tests had to be performed “assuming the current rate” when projecting the employee’s cash balance plan benefit at normal retirement age. Under that rule, if the rate in the prior year was low or 0%, many plans could not pass the backloading tests even if their rates were reasonably graded.

The new provision begins in 2023.

Cash Balance Plans: The Basics

A cash balance plan is a cross between a traditional defined benefit pension plan and a defined contribution plan, such as a 401(k). Generally, employers will contribute a set portion of a participant’s salary to the plan each year (known as the “pay credit,” which is usually equal to between 5% and 8% annually), and the participant’s account will also be credited with an interest credit each year.

Because the employer is required to contribute each year, the cash balance plan is ideal for very small businesses with few employees, so long as the business is sufficiently established to make the required payment each year (contributions on behalf of non-highly compensated employees will also be required).

The interest credit may be variable (for example, it may be tied to a stock index or plan assets) or fixed — but the employer was not permitted to vary the pay credit between employees. The employer assumes the investment risk associated with this investment credit, so that if the plan provides for a 5% annual investment credit and assets earn only 3% during the year, the employer may be required to contribute more to the plan.

When the participant retires, he or she receives an annuity based upon the amounts that have been credited to his or her account or has the option of taking a lump sum. These “accounts” are hypothetical in that the plan assets are not actually segregated into individual accounts, as they are in the case of a 401(k) plan.

Cash balance plans are technically defined benefit plans, so the annual total contribution limit for defined contribution plans does not apply. Instead, the contribution limit for cash balance plans is based on the amount that a participant may receive at retirement and will vary based upon age. An actuary can calculate backward (using the plan’s interest credit rate) from the benefit amount to determine each individual participant’s contribution level.

In general, the cash balance plan option is particularly attractive because the contribution limit will be much higher than the annual defined contribution plan limit.

Conclusion

Because of the most recent changes, cash balance plans may now be a viable option for a wider range of employers. Employers with frozen cash balance plans may also be interested in unfreezing these plans going forward.

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