Cash balance plans are becoming more and more popular. But little is know about cash balance plan interest crediting rate.
CB plans are defined benefit (DB) plans, and the formula used to calculate contributions in DC plans is analogous to the CB benefit formula. In a DB plan, the calculation is based on the amount each participant is required to contribute to the plan each year.
In the IRS’s regulations, cash balance plans are considered statutory hybrid plans and applicable defined benefit plans. They are subject to special rules and must meet certain criteria before being considered an “ABP.”
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Background
Cash balance plans continue to grow as the preferred retirement savings plan, especially in the health sector. Medical professionals are looking for methods to catch up on their retirement savings or accelerate their retirement timeline. A cash balance plan offers just what they want.
Cash balance contributions can change, but there are some restrictions and limitations. The plans can be amended to allow different contribution levels. Any reductions in contributions should be made before an employee works 1,000 hours during a given plan year.
The plan sponsor also can freeze or terminate a plan. Some plans offer additional benefits such as disability benefits, cost of living adjustments, spousal protections, etc.
What is the rate?
This article examines the implications of changing the interest crediting rate in a cash balance plan. It concludes that it is best to follow the IRS’s guidelines and use the market rates as a guideline for deciding which interest crediting rate is the best option.
A cash balance plan’s interest crediting rate may be based on a variety of variables. One example is the short index. This is a variable rate based on the yields of Treasury securities that are less than 10 years old.
Another example of an indexed cash balance plan is the consumer price index. Both of these variables are more or less investable and can be beneficial to a plan’s overall funding.
Although most new cash balance plans have a market rate interest crediting option, there are additional challenges to managing these types of plans. Because the market is so volatile, it is difficult to predict which rates will be the highest.
Various factors determine the best investments for a cash balance plan. Your business’ risk appetite, size, cash flow, and objectives, among other factors, may play a role in guiding investment decisions.
Cash Balance Plan Interest Crediting Rate
If you want to take a risk, you should choose a plan with a higher market rate to avoid paying extra tax on a lower ICR. However, you should consider all these options carefully and make the right choice.
While most new cash balance plans are set up with a market rate option for interest crediting, there are still many differences in the two methodologies. The difference between a market rate is important because it influences the interest crediting rate for DC plans.
In addition, the NEPC’s consultants will explain how the different interest-crediting rates will affect your investment strategy. In the meantime, you should focus on understanding the differences between market-rate and cash balance plan interest-crediting methods.
How does interest crediting work?
A cash balance plan is a type of defined benefit pension plan. A cash balance plan participant’s account is credited with a pay credit, which is typically 5 percent of their compensation.
An interest-crediting rate is calculated using a formula that is linked to an index. Because the employer pays all the risks associated with investment, the change in value of the fund does not affect the benefits that the participants are promised.
The flat rate is a flat interest-crediting rate that is the same each year. This is the most common type of cash balance plan. It is simple to administer and provides certainty for both participants and employers.
In the case of a flat-rate plan, the interest-crediting rate is the same as the third-segment average, but in addition, the plan’s flat-rate feature can help it attract more employees.
Among the three basic types of cash balance plans, a flat-rate plan credits a participant’s account at a fixed annual interest rate. An individual’s account is typically credited with a fixed interest-crediting rate.
In a DB plan, this crediting rate is the same for each year. Thus, a flat-rate plan provides greater security to participants than a DB plan.
Takeaway
A flat-rate cash balance plan is a defined-benefit plan that credits a participant’s account each year. The interest-crediting rate is fixed and increases annually. It is the same as a traditional pension, except that the employer bears the investment risk.
The Internal Revenue Service recently issued guidance on changes to the cash balance plan interest crediting rate. This Issue Snapshot analyzes the implications of the change.
A flat-rate cash balance plan is backed by its investment. Its annual return is equal to its interest-crediting rate.