Cash Balance Plans – Design and Testing Wednesday, May 1, 2013 Norman Levinrad, FPSA, CPC

Summit Benefit & Actuarial Services, Inc.

First Steps

• Clearly understand the client‟s objectives.

• Determine what plan they currently have in place and know the provisions of that plan.

• Find out if there was ever a prior DB plan.

• Establish all ASG and/or CG issues.

• Gather census data.

• Don‟t leave out any of the prior steps. You can‟t do a decent analysis without all this info. or else it blows up later.

Design Elements

• Usual design elements for all plans

• CB plan credits

• Guaranteed Crediting Rates

• Testing Considerations

The usual suspects

• Eligibility

• Entry Dates

• Class exclusions – impacts 401a26

• Normal Retirement Age – impacts combined plan testing

• In service distribution age - impacts funding policy

• Vesting - 3 yr cliff, equivalent to 2/20 if tested with a PS plan – cliff vesting could impact an HCE who leaves and is 100% vested

• Payment forms – usually lump sums allowed

• Death benefit

• Disability benefit

• Time of distributions

Factors affecting design of the CB credits

• 133 1/3 rule – the accrual rate in any year can‟t exceed the accrual rate in any prior year by more than 133 1/3%

• Current guidance is that for all plan purposes the current crediting rate must be projected to determine the accrued benefit at NRA for testing purposes.

• Projection must be done at the current crediting rate.

• The 133 1/3rd rule interacts with the CB plan interest crediting rate. Generally its only a larger plan issue and only comes into play if you have a service based crediting schedule, e.g.. CB credit is 1% of pay if 1 - 5 YOS; 2% of pay if 6 – 10 YOS, 3% of pay if more than 10 YOS. You need to test the accrued benefit at NRA under all possible interest credit scenarios to test the accrual rate against the accrual rate in any prior year. If you use a variable rate you may need a minimum crediting rate to satisfy the 133 1/3rd accrual rule.

Factors affecting design of the CB credits

• Similarly Situated Employee Requirement: Under this requirement an older employee cannot receive any less of a credit than a similarly situated younger employee simply because of age. A sponsor can have different credits for different employees based on bona fide business reasons:

• Period of service

• Compensation

• Position

• Date of hire

• Work history

• Other factors

Factors affecting design of the CB credits

• The Big Kahuna: Formula for credits for principals:

• Every shareholder/owner/partner funds their contributions and

benefits from their compensation package.

• What do these clients want? They want this to be a glorified 401k

plan. Can a DB plan ever give them what they really want? NO IT

CAN‟T!

Credits for Principals

• Nice and easy: • Flat $ credits for all principals covered

• % of Comp for all principals covered

• Combination: eg. $100,000 but not in excess of 40% of Comp.

• Exclude principals to be excluded from the plan by name.

• CB credits by age bands; by various objective classes (e.g. partnership date); etc.

• Impact of crediting rate on Normal and MV EBARs…more in a few minutes on this.

Credits by Name?

• Can you? Yes, there is no issue with similarly situated employee rule. Dr. Cohen cannot be similarly situated to Dr. Levin.

• Should you? What does this tell the client?

• Will you? Yes you often will – because you will sometimes have to.

• Does it raise cash or deferral issues?

• How are credits determined?

• Managing expectations is very challenging when the plan is designed this way.

Accrual Requirements

• 1000 hours?

• Prorated?

• Discuss advantages of each with client – effect on

shareholders who leave mid year and effect on

funding policy and ability to pay unrestricted lump

sums.

401a26 – the Minimum Participation Requirement

• Remember 401a26 – at least 40% of all eligible participants must receive a meaningful benefit.

• IRS follows the Shultz memo which defines meaningful as an annuity benefit at NRA of .5% of Compensation.

• Impact on 401a26? Could a credit for a principal of $10,000 not be meaningful under 401a26? Yes, it may not be under the Shultz standard.

• More about 401a26 later.

Formula for credits for other groups

• Flat $ - age neutral, comp neutral…appealing, easily understandable and usually cheap.

• % of Comp

• Combination: eg. 1.5% of Comp but not in excess of $1,000.

• Service bands – 133 1/3 rd rule applies

• Does your document tell you what happens if someone changes tiers mid-year? Always define tiers by status at 1st day of Plan Year!

Formula for credits for other groups

• Impact on 401a26?

• A flat $ credit that provides a meaningful benefit in year 1 may not in later years as group ages.

• A variable rate creates 401a26 volatility

• The higher the crediting rate, the lower the CB credit needed for staff to pass 401a26, but….it creates higher Normal and MV rates for principals

• Carve outs

• Can define the CB credit as the amount that provides an accrued benefit at NRA of .5% of Comp

• A corrective amendment to pass a26 that cherry picks the youngest people to pass may blow the similarly situated employee rule …do it by ascending comp instead.

• Impact of crediting rate on 401a26 …more on this later.

CB Plan Crediting Rates

• Must not exceed market rate (statutory)

• Acceptable yield rates per Final Regs:

• Treasury yields + margins (From Notice 96-8)

• Corporate yield: 3rd segment rate

• Funding segment rate (2-year average), or

• 417(e) segment rate (one-month average)

• Final regs added 1st and 2nd segment rates

• Funding or §417(e)

• 2007 prop regs allowed 3rd segment funding rates

• Cost-of-living indices + up to 300 bps

• Per proposed regs, a fixed rate cannot exceed 5% - still need final

regs on this.

• Can use the Actual Rate of Return (ROR) on Plan Assets as the

crediting rate!

• Includes positive and negative returns

• Only if plan assets are “diversified so as to minimize the volatility of

returns”

• Standard met if ERISA 404(a)(1)(C) met

• “by diversifying the investments of the plan so as to minimize the risk of large losses,

unless under the circumstances it is clearly prudent not to do so.”

• PPA‟s Preservation of Principal rule applies – cumulative credits are

preserved.

• Can use a RIC (Registered Investment Company) Return

(aka mutual fund)

• E.g., Vanguard 500

• Only if “reasonably expected to be not significantly more

volatile than

• the broad US equities market or

• a similarly broad international equities market”

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Interest Crediting Rate

• Why credit actual ROR?

• Assets and liabilities match each other

• If investment loss no make-up contributions

• Simply deposit pay credits (?)

• So is the investment risk shifted to employees (?) Partially, sponsor still has some risk to the

extent of the preservation of principal rule.

• Nonetheless, brokers/other advisors will sell as if assets and liabilities will always

match

• And will tell employers that investment risk is fully shifted to employees

• So may well be wave of future, particularly

with very risk averse clients

• How can we implement with all the uncertainty?

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Crediting Actual ROR – why not?

• Potentially harder to pass 401(a)(26)

• Need 40% / 50 participants at 0.5% of pay annuity benefit at NRA

• Measure on accrued benefit increase at NRA

• Low or negative returns will create problems

• Potentially harder to pass 401(a)(4)

• Combo plans often have HCEs receive major $ in CB plan and NHCs receive most of their $ in PS

• Owners‟ CB benefits leveraged by difference in projection rates

• E.g. PS at 8.5%, CB at 5%

• If crediting Actual ROR projection rate now some measure of plan asset return (most recent per IRS?)

• In high ROR year projection rate erodes or eliminates passing margin as HCE accrual rates higher (as

AB increase greater) while NHC (based primarily on PS) essentially unchanged

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Crediting Actual ROR – why not?

• Potentially harder to pay lump sums to HCEs under 100% rule.

• Pre PPA plans (e.g., 30-year Treasuries)

• Project to assumed payment at, say, 4 – 5%

• Discount at segment rates – say 5-6%

• Roundtrip often +/- 15% discount

• Crediting Actual ROR

• Project at assumed investment return

• Reasonable assumption may erode discount

• May require “real” overfunding to pay top-25

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Crediting Actual ROR – why not?

• Timing of contributions

• Where contributions not made on last day of year crediting ROR may

cause interest credits higher than actual amounts earned

• E.g. assets earn 33.33% first ½ year and lose 10% for last ½ – result

is 20% return for the year

• i.e., P * 1.3333 * .9 = 1.2 P

• Prior year contribution made end of first ½

• Contribution that lost 10% needs to credit 20%??

• How is ROR on plan assets defined?

Minimum Crediting Rates

• Can use Minimum Rates

• If your credit rate is a yield rate (segment rates or Rev. Notice 96-8

rates):

• Up to 4% minimum, applied annually.

• If your credit rate is actual ROR or RIC rate:

• Up to 3% minimum applied at ASD cumulatively! It is not an annual

minimum

• Similar to Preservation of Capital (statutory requirement providing

that ultimate distribution not be less than accumulation of pay

credits)

• Need to maintain a shadow account.

CB Plan Crediting Rate Issues - Summary

• Fixed Rate? 401a26 passing is stable; 401a4 testing is stable. Trustees understand the goal.

• Variable Rate? Discuss impact on 401a26 and 401a4 testing of a variable rate; creates instability – current guidance is that the current rate must be projected to determine the accrued benefit at NRA for testing purposes. Trustees don‟t understand the goal.

• ROR on assets? Variable rate on „roids! • Discuss impact on 401a26; 401a4 testing; 411a9; 133 1/3rd rule etc… of a

variable rate. Need much more guidance.

• Make sure client understand preservation of principal rule, and that they need face some investment risk.

Interaction of Crediting Rates on testing

• Example –

• HCE age 49; comp $250,000; CB credit $125,000; PS

cont $21,750

• NCHE age 38; comp $29,554; CB credit $1,000; PS cont

$2,069 (7% of comp)

• Consider:

• #1 CB crediting rate fixed 3%

• #2 CB crediting rate fixed 5%

#1 CB crediting rate fixed 3%

• 401a26 rate for NHCE = .43% < .5%

• 401a4 rates:

HCE Normal MV 10.68% 15.72%

NHCE 9.26% 10.44%

#2 CB crediting rate fixed 5%

• 401a26 rate for NHCE = .84% > .5%

• 401a4 rates:

HCE Normal MV

14.28% 19.37%

NHCE 9.82% 11.13%

The Funding Policy

• Statutory minimum?

• Statutory maximum?

• Recommended amount to keep the plan funded on a

termination basis?

• Amount to allow unrestricted lump sums to HCEs?

Investment Policy

• Defer to the Investment Advisor, but provide them

guidance to understand the issues:

• Coordination with the plan‟s guaranteed crediting rate.

• What are the Trustee‟s goals?

• To minimize volatility?

• To maximize return?

• To immunize themselves from risk?

Coordination issues with PS plan

• Tested together for 410b? If yes, then tested

together for all other purposes:

• 401a4

• Benefits, rights and features

• Problems with life insurance in the CB plan –is it possible

for this be non-discriminatory?

• Both plans must have the same plan year for them to

tested together.

Combined Deduction Limit under 404a7

• Covered by PBGC? If so, no combined deduction limit.

• If not covered by PBGC, subject to 401a7: • If PS cont is ≤ 6% of pay, no limit on DB deduction

• If PS cont is > 6% of pay, combined deduction limit is 31% of Comp

• If you are maximizing on the CB side PS cont will be limited to 6%.

Top Heavy Minimums

• CB plans don‟t work well if the CB plan provides the TH minimum – it will significantly override the CB account for older participants

• Always cheapest to provide the dual plan minimum via the 5% of pay contribution in lieu of the DB minimum. Need coordinating plan language.

DB/DC gateway issues

• The DB/DC gateway will depend on the credits provided to the HCEs and the ages of the HCEs. It will generally be between 5% and 7.5%.

• The gateway is provided by the PS contribution and the CB credits to NHCES. But $1 of credit does not translate to $1 towards the DB/DC gateway. For example a 2.5% CB credit and a 5% PS contribution will not necessarily satisfy a 7.5% gateway, because of how ANARs are determined.

• You can use the average of the CB plan ANARs for the NHCES as the amount towards the gateway. For example if the average NHCE ANAR is .7% and the DB/DC gateway is 7%, then a PS cont of 6.3% to all NHCEs satisfies the gateway. • This avoids a different PS cont as a % of salary for NHCEs to satisfy the gateway.

DB/DC gateway issues

• Any NHCE who benefits from the CB plan or the PS plan (any employer source) must receive the DB/DC gateway.

• Design the PS allocation requirement to provide the flexibility to provide statutory minimums (TH and DB/DC gateway) without ever needing corrective amendments under 11g – individual groups, no EOY employment requirement, 1 hour. Also allows sponsor to target PS contributions to different employees or classes at their discretion.

CB/PS plan offset arrangements

• Lots of non-compliance in this area: • Offsetting of current year‟s CB credit with current years PS

contribution

• Defining the CB account as the PS account balance

• Yada, yada, yada…..

• Why bother taking a easy to understand concept (i.e. a CB account), and make it complicated by using an offset? Since the CB credit counts towards the DB/DC gateway, what have you really saved the client?

• Questions?