Some Random Reflections on the PPA and Cash Balance Plans

The PPA has some interesting cash balance provisions, including a prohibition on cash balance plans whose interest credits exceed market rates of return.  The reason for this prohibition is clear enough: if an interest credit is higher than investment returns available in the market, the interest rate will favor younger plan participants, since they will have the benefit of the above-market rate for a longer period of time than older plan participants.  Or put another way, a compensation credit that will grow in synch with an above-market interest rate will have a higher present value for a younger employee than for an older employee, assuming, as we should, that present value will be determined with a market discount rate.   

This raises the question of what a market interest rate of return is. Suppose a plan provides that interest credits will reflect the return on an equity index, and if we like, a rather risky equity interest that might pay spectacular returns if things go well.  Suppose further that the cash balance plan says that your account will be credited with positive returns, but not negative returns.  In years of negative return, your account will still grow, but only to reflect new compensation credits. 

Is this a market rate of return?  Well no, you get the possibility of spectacular returns only if you are willing to shoulder the corresponding risks, which include loss.

But can a plan offer such an interest credit?  Possibly yes: the PPA says that a plan shall not be treated as failing to meet the market-rate interest credit requirement “merely because the plan provides for a reasonable minimum guaranteed rate of return or for a rate of return that is equal to the greater of a fixed or variable rate of return.”

So let’s put into our plan that interest credits are equal to the greater of our equity index or 1%.  If such an investment option were available on the market, I would certainly like to invest in it. 

I suppose that Treasury regulations might try to put a stop to this, focusing on the word “merely” and regard the above arrangement as abusive and thus not providing a market interest rate.  This would seem to be a stretch under the language of the PPA.  And what if the equity index were a standard market index, say the Willshire 5000.  Presumably this would not be abusive, but the problem is still there: anyone would love to invest in an instrument that gives you the full upside of an index but insulates you against any market declines.  Perhaps this can be fixed in regulations, but as I said, I think the language of the statute might make a regulatory fix a bit problematic.

It should also be said that the PPA says that an interest rate shall in no event result in the account balance or similar amount being less than the aggregate amount of pay credits.  So the statute actually makes it illegal to provide a true market rate of interest if the rate is pegged to any index that can go negative, since a participant’s losses are capped at the prior investment gains on a participant’s account.  In the real world, of course, your initial capital (in cash balance plans, the compensation credits) would also be at risk.

The drafters of the statute had a sensible idea about market rates of interest, but then wrote rules that are in effect conceptually incoherent. 

Now where is this likely to lead to problems?  I think primarily with cash balance plans adopted by small firms, where most of the rank-and-file employees will have a relatively short period of plan participation.  Here, the owners are likely to enjoy the favorable interest rate for a long period of time, while rank-and-file participants may not. (And you can probably exclude from cash balance participation those rank-and-file employees who are likely to have long periods of participation.) 

Section 415 of course puts some limits on how large a benefit an owner can get by defining interest credits in a way that provides the possibility of high returns but protects against the full impact of the possibility of losses.  But I also suspect that the next legislative push on cash balance plans will include proposals to allow cash balance plans to choose whether to be subject to either the defined benefit or defined contribution section 415 limit.  And if this happens, the planning possibilities for cash balance plans in small firms are perhaps not limitless, but getting there. 

By the way, does anyone think that any large or medium-sized businesses that do not already have cash balance plans are going to adopt new cash balance plans (or convert existing traditional defined benefit plans into cash balance plans)?  I don’t.  I just don’t see what benefits cash balance plans offer such firms over true defined contribution plans.

On the other hand, I do think there will be interest in new cash balance plans by small, owner-dominated firms, where cash balance plans already seem to offer some interesting planning possibilities.  But that is another blog for another time.  

Comments

[Norman Stein]

Responding to Robert Mitchell's comments: The statute says what the statute says, and it does say that the interest rate on a cash balance plan cannot exceed a market rate of return. I agree that a cash balance plan can certainly match the returns on whatever indexes are out there. I once made what turned out to be a bad CD investment: the rate of return was the higher of zero or 50% of a broad market index (I can't remember what the index was now, but it dropped during the life of the CD--I've put the bad memory out of my mind). An interest rate such as this would be no greater than a market rate of return. But without what the actuaries are apparently calling a haircut, i.e., the benefit of 100% of the equity index, with a minimum interest rate of 0% or higher, would not be a market rate. It would have to be something less than 100%.

We can debate the wisdom of whether this was a good or bad idea and the rule implementing it is not, as I pointed out, well written. But the idea behind it was at least this: such an interest rate would result in age discrimination, since the interest rate--which is not available to investors in an actual market--would be enjoyed for a longer period of time by younger employees. There is also a possibility of manipulation in small plans, where the owner of the plan sponsor gets the high rate of return while few of the business's regular employees get the rate of return for very long.

Having said this, I am not sure of the amont of our disagreement, if indeed we do disagree. I believe the statute clearly contemplates the kind of arrangment you mention--preservation of principle, but at the type of interest rate that insurance companies use in calculating the premium on such annuities.

I also would favor some sort of safe harbor for non-top heavy plans, since I believe that market and economic forces will ensure in those plans that the interest rate is a reasonable rate of return. A safe harbor would have to include a rule that the pay credits of all participants are credited with the same interest rates. (Or if the employee has a choice of interest rates, that all employees have the same choices.)

Also, it is probably worth noting that you can provide higher benefits either with a higher interest credit or a higher pay credit. If you do it with a pay credit, the possibility of age discrimination or favoring higher paid employees through the benefit formula disappears

[David Fleiss]

Evidently the staff of the Joint Committee on Taxation interprets the statute to require a minimum interest rate of 0%.

Page 155 of the Technical Explanation of H.R. 4 states that:

"A plan satisfies the interest requirement if the terms of the plan provide that any interest credit (or equivalent amount) for any plan year is at a rate that is not less than zero and is not greater than a market rate of return."

However, the Technical Explanation goes on to summarize the statutory "preservation of capital" requirement, which only applies when "[a]n interest credit (or an equivalent amount) [is] less than zero."

The appearance of these two sentences in the same paragraph suggests that the JCT staff, and perhaps Congress, is confused about the intention of the statute.

[Robert Mitchell]

Your commentary suggests that cash balance plans should be subject to full market risk.

This ignores the employee benefit nature of the plan, and its reliance on the rules found in defined benefit plans. The employer bears the investment risk in these plans, and the employee gets the promised benefits. The employer then is responsible for managing the investment decisions to make the employee benefit adequately funded.

Only the minority of cash balance plans use a method of crediting investment income based on market indexes. Far more typical are the plans that offer a fixed rate of return, usually based on some external interest rate such as Treasury yields of one year bills to 30 year bonds.

You might also recall that insurance companies sell annuity contracts that provide a minimum guarantee of the premiums deposited, as a feature of their variable annuity contracts. Thus, the market has a tool to match this statute.

Finally, large cash balance plans try to make employees feel more secure, not less. They are not designed for active trading, for management by the participant, nor for the distraction (and distress) of worry about the market's effect on their retirement nest egg.