Market based cash balance plans

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Market based cash balance plans

  1. 1. Market-Based Cash Balance Plans Minneapolis Pension Council December 19, 2013
  2. 2. Outline ƒ Brief cash balance overview ƒ History of interest credit options ƒ Issues & answers 1
  3. 3. Cash Balance Plan Overview ƒ It’s a DB plan that looks like a DC plan ƒ Big DB deductions, DC-like simplicity 2
  4. 4. Cash Balance Plan Example DB/DC combo ƒ Common for professional firms ƒ Enables large deductible contributions for owners
  5. 5. Cash Balance Plan Example DB/DC combo: cash balance & profit sharing { This example is for a PBGC-covered plan, Frankenstein Mfg. Inc. { Gateway here is 7½% DC; Igor & Inga get 3% cash balance credits { A PBGC-exempt professional firm may need to limit DC er contrs to 6% Age 2013 Pay Cash Balance Credit PS & 3% Safe Harbor 401(k) & Catchup Total Dr. F’stein 60 $255,000 $230,000 $33,500 $23,000 $286,500 Igor 40 50,000 1,500 3,750 whatever 5,250+401k Inga 30 30,000 900 2,250 whatever 3,150+401k
  6. 6. Cash Balance Buildup 5 Pay Credits + Interest Credits = Cash Balance! Year Pay Credit Interest Credit (@ 10%) Cash Balance 1 $100,000 $0 $100,000 2 100,000 10,000 210,000 3 100,000 21,000 331,000 4 100,000 33,100 464,100 5 100,000 46,410 610,510 6 100,000 61,051 771,561 7 100,000 77,156 948,717 8 100,000 94,872 1,143,589 9 100,000 114,359 1,357,948 10 100,000 135,795 1,593,742
  7. 7. History of Interest Credit Options ƒ Notice 96-8 safe harbors ƒ PPA “statutory hybrid plan”: market rate of interest ƒ Notice 07-06: added 3rd funding segment rate ƒ 10/19/2010 proposed regulations 6
  8. 8. History of Interest Credit Options „ Notice 96-8: Bond indices w/ margins + 417(e) [30-Year T] Standard Index Associated Margin The discount rate on 3-month Treasury Bills 175 basis points The discount rate on 6-month Treasury Bills or 12-month Treasury Bills 7 150 basis points The yield on 1-year Treasury Constant Maturities 100 basis points The yield on 2-year Treasury Constant Maturities or 3-year 50 basis points Treasury Constant Maturities The yield on 5-year Treasury Constant Maturities or 7-year Treasury Constant Maturities 25 basis points The yield on 10-year Treasury Constant Maturities or any longer period Treasury Constant Maturities 0 basis points Annual rate of change of the Consumer Price Index 3 percentage points „ Notice 07-06: long-term corporate bonds, PPA 3rd segment rate, 30-Year T, or rates in 96-8
  9. 9. PPA – Statutory Hybrid Plan Definition DB plan where portion of accumulated benefit is: „ Current hypothetical account balance (cash balance plan); or „ Accumulated percentage of final average pay (PEP plan) 8 What you get „ Whipsaw relief „ Age-discrimination relief What you give „ 100% vesting in 3 years (entire benefit) „ Interest Credit can’t exceed “market rate of return”
  10. 10. History of Interest Credit Options „ 2010 Proposed Regulations – Rate of return on plan assets, if prudently diversified 404(a)(1)(C) – Rate of return on regulated investment company • Mutual funds (e.g., S&P 500 index) • Should not be more volatile than broad equity market – Fixed 5.0% (with 411(d)(6) relief if switch from 3rd segment rate) – “Greater of” rates [floors] • Max annual 4% floor if IC rate is fixed income safe harbor • Max cumulative 3% floor if equity-based IC rate 9 „ No final regulations yet
  11. 11. History of Interest Credit Options Interest Credit Floor Example ƒ Interest Credit = S&P 500 (actual from 2007 – Oct 2010) ƒ Principal Credit = $10,000 per year 10
  12. 12. Interest Credit Example Preservation of Capital Example ƒ Interest Credit = S&P 500 (actual from 2007 – Oct 2010) ƒ Principal Credit = $10,000 per year 11
  13. 13. Market-Based CB Plan Issues 1. Investment risk (assets < cash balance accts) 2. §401(a)(4) nondiscrimination testing 3. Top-25 HCE lump sum restrictions 4. Overfunding (account > §415 max lump sum) 5. §401(a)(26) 50-ee/40% “meaningful benefits” 6. DB accrual rules 7. Administration – lump sum & annuity payouts 12
  14. 14. Market-Based CB Plan Issues 1. Investment risk (assets < cash balance accts) Issue Answer 13 “Preservation of Capital” rule: • Payout can’t be less than sum of pay credits • i.e. cumulative return for each participant can’t be less than 0% Investment risk can be lower than a traditional cash balance plan. Can manage risk, but not escape it. Possibilities include: • Conservative investments • Cap interest credits to capture investment gains for plan sponsor • Delay distribution
  15. 15. Market-Based CB Plan Issues 2. §401(a)(4) nondiscrimination testing Issue Answer 14 Successful nondiscrimination test may depend on “turbo charging” • DC contributions projected @ 8½% • CB credits projected at lower rate • CB credit produces a lower testing benefit than an equal DC contrib Market-based plan may project at a higher rate • Less turbo-charging advantage IRS position is that CB testing should be done at previous year’s crediting rate. Can improve passing chances with: • Conservative investments • Capped interest credits
  16. 16. Market-Based CB Plan Issues 3. Top-25 HCE lump sum restrictions Issue Answer 15 Funding “whipsaw” • CB account projected at market rate • Discounted back at low IRS rates • Produces liabilities higher than total cash balance accounts • If assets < 110% of liability, can’t pay lump sums to top 25 HCE’s Current actuarial practice is to project accounts at expected long-term return. Can improve results with: • Conservative investments • Capped interest credits • Extra funding to reach 110%
  17. 17. Market-Based CB Plan Issues 4. Overfunding (account > §415 max lump sum) Issue Answer 16 With strong investment returns, individual account balance can exceed §415 maximum lump sum • Money is trapped in the plan • Excess subsidizes other participants’ benefits Can make it up outside the plan, or reduce risk with: • Conservative investments • Capped interest credits • Lower pay credits to “leave room” • Delayed distribution until §415 dollar limit catches up
  18. 18. Market-Based CB Plan Issues 5. §401(a)(26) 50-ee/40% “meaningful benefits” Issue Answer 17 Benefits must be “meaningful” to count participant as covered in plan IRS position (de facto safe harbor) is a pay credit generating a ½%-of-pay benefit at normal retirement age • Projections after a bad investment year produces low benefits • Might not be enough people at ½% to meet the 50-ee / 40% test Can reduce risk with: • Conservative investments • A floor (e.g. 0-3% cumulative) on interest credits
  19. 19. Market-Based CB Plan Issues 18 6. DB accrual rules Issue Answer Need to satisfy DB accrual rules • Designed to prevent “backloading” of benefit accruals to get around a vesting schedule • 3 alternative rules, most cash bal plans rely on 133-1/3% rule • No future benefit accrual can be > 133-1/3% of earlier accrual • Projections at low return rates produce low early accruals Can reduce risk with: • Reduced age or service grading of cash balance credits • Conservative investments • A floor (e.g. 0-3% cumulative) on interest credits
  20. 20. Market-Based CB Plan Issues 7. Administration – lump sum & annuity payouts Issue Answer 19 Pure market-based account balance is unknowable beyond today • Need to provide survivor annuity options in addition to lump sum payout • Participant needs 30 days for annuity election Can make balance knowable by: • Crediting actual return through termination with payout reasonably soon thereafter, or • Making all payouts after year end
  21. 21. Contact Information 20 Mark Schulte, FSA, EA, MAAA marks@vaniwaarden.com 612.596.5971 Jim van Iwaarden, FSA, EA, MAAA jimvi@vaniwaarden.com 612.596.5961 Van Iwaarden Associates 840 Lumber Exchange 10 South Fifth Street Minneapolis, MN 55402 www.vaniwaarden.com 1.888.596.5960

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