However, employers received much of the clarity they were waiting for about the design and structure of cash balance plans when the Internal Revenue Service (IRS) issued proposed and final regulations (see IRS Corrects Hybrid DB Plan Rule), and Sibson says the hybrid appeal is worth another look in light of this legal clarity (see Bright Future Seen for Cash Balance Programs).
In a Spotlight report, Sibson says the potentially compelling reasons for employers to consider a cash balance plan are:
- Financial Efficiency A traditional DC plan is the approach to follow for employers that want to “set it, and forget it” because the cost of the plan is fixed: x percent of pay. However, in a simple cash balance plan the apparent cost of the plan is x percent of payroll, but the expected economic cost of the plan can be much less. The source of this savings is the differential between the rate that a plan will credit on employee accounts (which is often the 10-year or 30-year Treasury rate) and the discount rate. Under funding and accounting rules, the discount rate is based on corporate investment grade bonds. Given recent market conditions, this differential can result in a 1 to 2 percent spread, potentially saving as much as 2% of payroll each year (or more, if emerging investment performance exceeds the rate earned on corporate bonds).
- Mitigating a Significant Financial Risk Compared to a Traditional DB Plan A traditional DB plan is exposed to both an investment risk (through its assets) and an interest-rate risk (through its liabilities). When the two risks go the wrong way — assets going down while liabilities increase — plan sponsors have experienced a “perfect storm.” And, while a cash balance plan is a DB plan, under a typical feature where the annual interest credit is set at a market rate (e.g., 30-year Treasuries), the interest-rate risk on the liabilities is significantly muted without needing to introduce complex interest rate hedging techniques that one would need in a traditional DB plan. The reason for this is simply that whereas lower discount rates drive up a typical DB plan’s present value of future benefits (i.e., the plan’s liability), lower discount rates usually reduce a typical cash balance plan’s interest crediting rate, thereby offsetting the increase in the liability due to lower discount rates.
- Universal Coverage If employers shift the primary retirement vehicle from a traditional DB plan to a traditional §401(k) plan, one group of employees is left out in the cold: those employees who are unable to save money in the §401(k) plan and, therefore, receive no employer match. Although typically not a substantial portion of the population, it is nevertheless a group about which the human resources department is often concerned. A cash balance plan fills this gap because, like a traditional DB plan, it covers all employees.
- Balance of Risk Many employers believe that their assumption of 100% of the financial risks of the retirement program is too far to one extreme. However, a growing number of employers think that having employees assume 100% of the risks goes too far in the other direction. A cash balance plan operating in tandem with a DC plan provides a reasonable middle ground.
- Benefit Design Flexibility Because a cash balance plan is a DB plan, it can be used to meet employers’ personnel goals in ways that are not available to DC plans. For example, they can be (although not often are) the basis for providing early retirement windows and spousal benefits.
- Passing Non-Discrimination Testing Many DB plan sponsors closed their DB program to new hires in the past few years. If this has not already created non-discrimination problems, it is likely to do so in the future as the DB population ages and becomes higher paid. Redirecting a portion of current DC accruals into a cash balance feature in the DB plan (effectively allowing new participants into the DB plan) may make it easier to pass the non-discrimination test for the closed DB plan.
Advantages of Cash Balance for Employees
In its Spotlight report, Sibson Consulting said from the employees’ point of view, there are two main advantages of a cash balance plan:
- Preservation of Investment Principal Cash balance plans typically provide a feature that DC plans do not provide under the commonly elected investment options: account values that can only increase from year to year. Essentially, cash balance plans act like stable-value funds providing a dependable floor of protection. Further, although the interest credit in a cash balance plan might seem conservative compared to traditional DC investments, participants could compensate for this conservatism by allocating a larger portion of their DC accumulation to equities.
- Longevity Protection Surveys have shown that one of the two major fears of employees who are about to retire is outliving their money. (The other is a medical catastrophe that wipes out savings.) Because a cash balance plan is a DB plan, it must offer the option of receiving a lifetime payout rather than a lump sum. To some extent, this also serves as a floor of protection against outliving one’s money.