Have high earners put retirement savings on the back burner?

Plan sponsors that have shied away from cash balance plans due to fear of under- or overfunding may want to reconsider.

Typically, owners, principals, high earners and those close to retirement get the most value from a cash balance plan, a defined benefit option that allows participants to save large sums for retirement more quickly than by participating only in a 401(k) and profit sharing.

“It’s a vehicle that really allows people to sock away a lot of money, especially in the last five to 10 years before retirement, and make up considerable ground,” says Anthony Phillips, national sales director of retirement plans and asset services for BOK Financial.

Cash balance plans also may enable high earners to reduce their modified adjusted gross income below $200,000 so they don’t have to pay a net investment tax on unearned income, Phillips says, adding that offering a cash balance plan may help attract and retain top talent.

Reducing the Impact of Market Volatility

Although they’re defined benefit rather than defined contribution, cash balance plans look and feel to participants more like a 401(k). For instance, with a cash balance plan, each participant has an “account” they can sign on to and watch grow, just as they would check on a 401(k) balance.

However, like traditional defined benefit pension plans, fixed-rate cash balance plans have had the issue of unstable funding. With the fixed-rate plans, an employer annually provides a contribution credit and an interest credit—aka crediting rate—to each participant. The contribution credit typically is a percentage of the participant’s annual compensation or a flat dollar amount. If the investments in the plan perform poorly, such as when financial markets have a rough year, the plan will be underfunded because it will still owe participants both the pay credit and fixed-interest credit they were expecting.

For example, if a plan guarantees a crediting rate of 5% but has an actual return of negative 18%, that means the plan has a 23% shortfall, which will need to be made up. If the shortfall is not made up and an employee retires, the plan may be unable to cover the lump sum the individual expects to receive.

On the flip side, if the actual return is greater than the fixed rate, the plan will be overfunded and require a smaller contribution, which also means a smaller tax deduction, Phillips explains. Any fluctuation in annual contributions is problematic because, generally, participants want stability, so they can plan their contributions and their tax savings accordingly.

To contend with this issue of over- or underfunding, an alternative is a market return cash balance plan. This type of cash balance plan credits participants’ accounts based on how well the plan’s assets perform. The plan’s assets are managed as a pool—rather than by individual account—but this option also gives the plan sponsor the freedom to adopt an investment strategy that works for the business.

Phillips says he believes last year’s market woes will be moving more businesses that sponsor cash balance plans away from the fixed-rate approach and toward market-rate plans. “It just gives you more predictability and flexibility,” he says.

3 Questions to Consider

Plan sponsors deciding whether to offer a cash balance plan should ask themselves the following:

• Are 401(k) contributions and profit sharing maxed out?
• Does the company have the appetite and ability to put money in a cash balance plan for the next three years?
• Is the company also willing and able to contribute 6% of employees’ pay to their retirement savings—i.e., 6% total, taking into account all employer-offered retirement plans?