Friday, September 6, 2013

Cash Balance Plans Q&A - Graf Stiebel & Coyne

Cash Balance Plans Q&A - Graf Stiebel & CoyneGRAF & STIEBEL TEN QUESTIONS ABOUT CASH BALANCE PLANS 1. What is a cash balance plan? A cash balance plan is a defined benefit plan that looks and operates like a defined contribution plan (only with higher contribution limits). In a cash balance plan, the participant’s accrued benefit is expressed in terms of a hypothetical account balance. Each year, the participant’s hypothetical account receives an allocation (a “pay credit”) and notional earnings (an “interest credit”). The pay credit is often a fixed dollar amount for highly compensated employees based upon age and a fixed percentage or dollar amount for non-highly compensated employees, regardless of age. For example, a participant may receive an annual pay credit of $3,000 and an interest

credit of 5%. To determine the appropriate formula for a cash balance plan, a census of employee data is required. 2. How is a cash balance plan different from a traditional defined benefit plan? A traditional defined benefit plan typically provides a uniform benefit for all participants at normal retirement age. The only variable in such plans is the annual contribution required from the employer to provide the promised benefit at retirement. Because the benefit promised to participants is the same regardless of age, the employer is often required to make a larger contribution for older participants because they have less time to accumulate earnings. In a cash balance plan, the annual contribution consisting of a pay credit and an interest credit is determined at the outset. The only variable in such plans is the benefit that accrues to each participant (expressed as a percentage of compensation). Thus, cash balance plans are able to leverage the additional time younger participants have to accrue earnings to reduce the employer’s total contribution, just like a cross-tested defined contribution plan. 3. What problems have arisen with cash balance plans? Cash balance plans have been plagued by two problems: age discrimination issues and the “whipsaw effect.” Some federal courts have held that because younger participants in a cash balance plan accrue more interest credits than older participants (because they have more years to retirement), such plans are inherently age discriminatory. These decisions, along with an IRS moratorium on issuing cash balance determination letters, cast a cloud over the viability of cash balance plans. In addition, the previous IRS rules for calculating lump sum payments often resulted in distributions greater than the hypothetical account balance. Known as the “whipsaw effect,” this anomaly made cash balance plans less attractive to certain employers. 4. Have these problems been corrected? Yes. First, the Pension Protection Act of 2006 (“PPA”) provides that a plan will not be treated as discriminatory if a participant’s accrued benefit as determined as of any date under the plan is equal to or greater than that of any similarly situated, younger individual. Second, the PPA eliminates the whipsaw problem by allowing a lump sum distribution to equal the hypothetical account balance. Graf & Stiebel Cash Balance Plans 5. How is the interest credit determined? Beginning in 2008, the PPA requires that a cash balance plan credit interest at no more than a “market rate...

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