Investment Considerations for Cash Balance Plans

By Bobby Moyer, CFA, CFP®, CAIA

Bobby Moyer, CFA, CFP®, CAIA

Bobby Moyer, CFA, CFP®, CAIA Chief Investment Officer

Cash balance plans have gained in popularity over the last number of years because of the tax savings opportunities available to high-earning business owners and executives. Cash balance plans offer characteristics of both defined contribution plans, such as 401(k) plans, and defined benefit plans, often referred to as pension plans.

Components of Cash Balance Plans

There are two sides to a cash balance plan, the assets which are represented by the investment account and the liabilities which are specified in the plan document, usually based on a formula consisting of an annual percentage of pay or fixed dollar amount plus interest credits at a designated rate. The liability is the sum of all benefits owed to the participants in the plan.

The interest crediting rate is flexible, but changing it could have other implications. The rate is usually set between three and five percent. By setting a low interest rate, the investment account can be invested in a more conservative manner meaning less risk to the company; however, it means the value of each participant account will grow at a low rate and potentially much lower than an aggressively positioned participant account. Usually this is not a problem because for high-earners, the significant tax savings outweigh a lower investment return and for low earners, they may be receiving a benefit that would not be received if the plan was not established. Additionally, the crediting rate may influence the flexibility of the testing to get the highest maximum tax deduction for certain employees. The interest level set and company demographics will influence the flexibility.

Because there is a liability to the company, which is impacted by the value of the cash balance investment portfolio, we believe the investment management of the cash balance portfolio should be risk-focused. When constructing a portfolio, you should be taking into account the interest crediting rate, the risk tolerance of the business owner or business directors and the understanding that the business leadership has of how cash balance plans work.

If too much risk is taken and the portfolio value is below the liability, either the owner(s) will need to reduce his or her benefits or the company needs to make a contribution to make up for the shortfall, neither which may be preferred by the owner. If the extra risk pays off and the portfolio is able to generate returns greater than five percent, the excess return may be able to be used to offset future contributions which would reduce some of the tax benefits that are received from the contributions. If a guaranteed rate of return above five percent was possible with no risk, we would be foolish to sacrifice that return just so the tax deduction can be larger. However, this is not the case. In order to target a much higher return, you need to take on more risk which could lead to the undesired scenario of either reducing owner benefits or making a larger contribution. Given this trade-off, we believe not taking excessive risk is appropriate, unless this level of risk is fully understood and accepted by the plan sponsor. Please understand, the recommended portfolio does have risk. It will experience volatility and could suffer periods when the return is negative.

Cash balance plans can be great tools to assist high earners defer taxes and save for retirement. But if not understood by the plan sponsor and managed appropriately, both from a plan design and investment perspective, they could create an unfavorable experience.

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— Topics: 401(k), Retirement, defined contribution