IRS Clarifies SECURE 2.0 Cash Balance Backloading Test Changes

The Internal Revenue Service issued a notice on December 20 detailing the implementation of several items in the SECURE 2.0 Act of 2022, such as automatic features and tax credits. The notice also clarified the reforms to cash balance plans in SECURE 2.0.

Section 348 of SECURE 2.0 provided that cash balance plans that use pay credits and variable interest credits can assume a crediting rate is reasonable provided they do not exceed 6%.

Cash balance plans are a type of defined benefit plan for which the benefit is presented to participants as a stated account balance. The balance accrues annually based on a percentage of the participant’s pay, often increasing with age and/or tenure, and an interest rate–sometimes fixed and sometimes tied to a benchmark, such as Treasury returns.

These savings plans have to pass backloading testing per section 411 of the Revenue Code to ensure that they do not excessively privilege older employees. Plans are not allowed under the testing to increase total accrual credits by more than a third from one year to another, say from 3% to more than 4%.

By permitting a variable interest rate as high as 6% in testing, SECURE 2.0 makes it easier to pass the backloading test and therefore easier to provide higher pay credits to more tenured employees. Under the law, a hypothetical 3% pay credit could be increased by 6% to 3.18% for the purposes of testing.

The IRS notice explains that when making plan amendments to account for Section 348, those amendments cannot result in a situation where “the employee’s benefit accrual is ceased, or the rate of an employee’s benefit accrual is reduced, because of the attainment of any age.”

John Lowell, a partner with pension consulting firm October Three, says that a cash balance plan cannot reduce a participant’s balance or their rate of accrual as a consequence of implementing Section 348.

Lowell says that prior to the Employee Retirement Income Security Act, many plans were backloaded to such a degree that they were widely viewed “as abusive.” But subsequent regulations and laws made backload testing unworkable in some cases, because plans had to use the rate of return that was credited from the previous year, which could be as low as zero.

This change will help “open the door for accrual cash balance plans that are age of service weighted,” which in turn can provide valuable attraction and retention tools in a multi-generational workforce, Lowell says.

Lowell emphasizes that to use a 6% return, it must still be reasonable based on market models. There are circumstances, he notes, in which “6% would not be a reasonable assumption.”