Defined benefit (DB) plans’ decline among private companies has been well documented, in part because sponsors wanted to move away from carrying a liability they may not be able to meet. “A lot of times the management of the defined benefit plan got in the way of a sponsor actually running their business,” says Kelly Coffing, principal and consulting actuary with Milliman in Seattle, Washington.
Those problems remain and traditional DB plans are not making a comeback. But that doesn’t mean you should write off DB plans’ business potential. In the right circumstances, cash balance DB plans – plans which define a participants benefit in terms of the account balance, not a promise of payments - continue to get a positive response from plan sponsors. Industry participants report that a growing number of employers are considering the combination of defined benefit cash balance plans and profit sharing. Plan administrators Kravitz Inc. reports U.S. cash balance plans held $1 trillion at the end of 2013, or 28 percent of all DB plan assets, versus 3 percent in 2001.
Cash Balance Basics
There are different types of cash balance DB plans but they share several characteristics, says William Charyk, a partner with law firm Arent Fox and president of the Institutional Retirement Income Council. The plans resemble individual defined contribution accounts in the sense that the guarantee is expressed as a lump sum or account balance equivalent to the contributions that have been made “plus or minus the earnings results.” A traditional DB plan promises a series of monthly payments for life, regardless of the size of the pension.
That appeals to sponsors who want to avoid the DB plans’ mismatch between funding and liabilities that can come from volatile markets or, often, overly optimistic assumptions about the funds’ investment returns. Participants like the plans because they can see a notional account balance instead of a projected pension income benefit.
Identifying the Ideal Prospect
Cash balance plans work best when the demographics line up, says Erica Harper, partner with actuarial firm Harper Danesh LLC in Rochester, New York. Ideally, the plan will have a smaller number of older, highly compensated employees and a larger number of younger, lower-compensated staff members. The business also needs stable free cash flow to support the required contributions so companies with cyclical cash flows might not find the plans as attractive, even if the demographics work.
Robert Danesh with Harper Danesh points out that combining a cash balance plan with a 401(k) can help meet nondiscrimination tests and boost older participants’ pretax contributions. He gives the example of a medical office with one older doctor and five staff members; the business contributes 7.5 percent of employees’ pay to the 401(k). Assuming the plan passes the discrimination tests, the addition of a cash balance plan lets the doctor increase his or her retirement savings significantly. “I’ll use the doctor as example who is in their fifties and hasn’t really saved as much as they’d like for retirement,” he says. “This is a nice way to ramp it up fast. You can put in these plans and over 10 years gain well over a million or $2 million pretax if you had that kind of revenue to put in it.”
Cash balance plans can also work for firms in which a reasonably large number of highly compensated employees who will not be put in the plan. In a law firm, for example, the plan could cover the partners and perhaps a few staff but not the associates. “The fact that the associates are highly compensated, and, yet, not in the plan, helps the plan pass the nondiscrimination test,” Charyk says. “If you go into the other professions and you have the younger professionals who aren’t at the ownership stage, if they’re excluded, it simply makes the plan easier to pass without having to put a very large amount in for the staff.”
Some employers with traditional DB plans are also expressing interest in cash balance plans, says Charyk. If the sponsor decides to de-risk the plan and convert the accrued assets to paid-up annuities, for instance, changing to a cash balance plan going forward can be a viable solution. For other companies, if the DC-only approach isn’t providing the desired results from a recruiting and retention perspective, adding a cash balance plan could satisfy both the chief financial officer and the head of human resources, says Coffing.
Points to Consider
Consultants need to remember two points about cash balance plans, says Harper. First, the government’s nondiscrimination rules are subject to change, which could reduce the plans’ attractiveness. Second, these plans are not off-the-shelf solutions. “You still need an actuary and you still need to do all the requisite government filings every year and all the actuarial calculations that we would do to determine benefits,” she cautions. “The minimum contribution requirements and all that are still required, just usually on a smaller scale.”