Questions and Answers
What are the minimum participation requirements for a cash balance plan?
A cash balance plan has the same participation requirements as traditional defined benefit plans. The minimum participation rule for defined benefit plans is that an eligible employee must become a participant in the plan by the later of (a) attainment of age 21, and (b) the completion of one year of service. An exception to this rule is when a plan has 100 percent immediate vesting of the benefit. Then, an eligible employee must become a participant in the plan by the later of (a) attainment of age 21, and (b) the completion of two years of participation service.
When determining if an employee meets the service requirement, hours of service can be considered. An eligible employee can be required to earn up to 1,000 hours in order to receive a year of service. [I.R.C. § 410(a)(3)(A)] The computation period to determine whether any hours threshold is first measured on an anniversary basis, meaning the 12-month period beginning when the eligible employee first works an hour of service for the employer. If the employee does not meet the requirements in his or her first anniversary year, then subsequent years can continue to be measured on an anniversary basis, or some other basis specified in the plan, such as the plan year or, if different, the calendar year. For administrative ease, the most common approach to counting service after that initial plan year is to move to a plan year or calendar year basis.
With certain limited exceptions, a cash balance plan, like any other defined benefit plan, must benefit a number of employees equal to the greater of 40 percent of all employees of the employer or two employees (one, if there is only one employee of the employer) or, if less, 50 employees. [I.R.C. § 401(a)(26)]
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When do employees join a cash balance plan?
Eligible employees become participants in the plan once they meet the participation requirements outlined by the plan. Beyond the participation requirements, a plan can have specific plan entry dates. These can be no later than the earlier of (a) the first day of the plan year after satisfying the participation requirements, and (b) six months after satisfying the participation requirements. [I.R.C. § 410(a)]
Example. A plan with a calendar plan year and a participation requirement that an employee must be age 21 with one year of service could have plan entry dates of January 1 and July 1. Entry dates such as these are often chosen to ease administration in collecting pay and/or hours of service information for the plan.
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How is normal retirement defined in a cash balance pension plan?
A cash balance plan needs to define normal retirement just like any other defined benefit plan. Normal retirement cannot be later than a person's attainment of age 65 and the fifth anniversary of the date the employee first became a participant in the plan. [I.R.C. § 411(a)(8)] Since a person would likely be vested prior to the fifth anniversary of participation, particularly under the PPA 3-year vesting requirement for cash balance plans, many cash balance formulas would simply define normal retirement as age 65
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How are benefits typically paid from a cash balance plan?
Due to the nature of cash balance plans, which communicate the value of the benefit to participants in the form of a lump sum, most cash balance plans have a lump-sum option that is available to participants, generally when they terminate, retire, or leave for any other reason. Assuming they are available, lump sums are by far the most prevalent option selected by plan participants.
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What are required forms of distribution for a cash balance plan?
Since they are defined benefit plans, the normal form of benefit under a cash balance plan needs to be an annuity. To define the amount of the annuity, the notional account must be converted to an annuity payment. This conversion is based on interest and mortality assumptions defined in the plan.
Other forms of payment may be possible as well. Cash balance plans tend to have fewer optional forms of payment than traditional defined benefit plans, simply because most benefits are paid out as a lump sum. However, when a traditional defined benefit pension plan is converted to a cash balance plan, many optional forms of payment that had been available must be protected with respect to benefits accrued prior to the conversion. [I.R.C. § 411(d)(6)]
If an organization chooses to simplify the forms of payment when converting to a cash balance formula, many of the optional forms of payment may need to be preserved. One option is to preserve the optional forms on the benefits accrued through the date of conversion, but prospectively eliminate them with respect to future benefit accruals. [Treas. Reg. § 1.401(a)(4)-4(b)(3)] This may be a more feasible option if a plan, at conversion, offers a two-part benefit (the A+B approach), where the first part is the benefit earned through date of conversion (with the protected optional forms retained) and the second part is the cash balance benefit starting with a $0 notional account balance (with the protected optional forms eliminated prospectively). The preserved optional forms, which are only available to pre-conversion participants, would need to be tested for nondiscrimination each year going forward, because those optional forms were not prospectively eliminated entirely, but are simply not available to the new post-conversion participants.
It is possible to eliminate the availability of certain optional forms from a defined benefit plan, even with respect to pre-conversion participants, although the requirements are complicated and the scope of optional forms that can be eliminated is rather narrow. [Treas. Reg. §§ 1.411(d)-3(c), (d), (e) & (f)] For these reasons, most employers converting an existing plan to cash balance choose not to eliminate optional forms available under the plan prior to the plan conversion in regard to benefits accrued prior to the conversion. Nevertheless, a plan could eliminate the optional forms that do not need to be preserved and either:
- Continue to provide all other forms under the cash balance plan; or
- Restrict some of the other forms to current participants, because the new participants do not have accrued benefits with respect to which those other forms need to be preserved, such that new (post-conversion) participants would have a more limited set of benefit options available.
If the latter of these two alternative options is used, the optional forms retained for pre-conversion participants would need to be tested for nondiscrimination each year going forward, because the optional form would not have been prospectively eliminated, but would also not apply to the new post-conversion participants.
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What limitations apply to the size of a cash balance plan benefit?
As with all defined benefit plans, cash balance plans are subject to benefit limits, which include:
- limiting pay recognized for purposes of calculating pay credits, inflation indexed to $245,000 for 2009 [I.R.C. § 401(a)(17)]; and
- imiting the ultimate benefit amount payable from the plan. [I.R.C. § 415(b)]
Many companies sponsor nonqualified restoration plans designed to make up (restore) the portion of the tax-qualified cash balance plan benefit not available to a participant due to the benefit limits.
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How is the ultimate benefit amount limited under the law?
Under the rules of IRC Section 415(b), the maximum annual benefit payable from the plan is the lesser of:
- a dollar limit; or
- compensation limit.
New regulations under IRC Section 415 were finalized and published April 5, 2007 in the Federal Register. These new regulations are generally effective for limitation years beginning after June 30, 2007, which for plans with calendar limitation years is January 1, 2008. A limitation year is the annual period over which the dollar or compensation limit is applied and is the calendar year, unless the plan specifies another consecutive 12-month period as the limitation year. [Treas. Reg. § 1.415(j)-1] The summary in this Answer Book is based on these new regulations.
A grandfather rule is available for benefits accrued or payable under a plan as of the end of the limitation year immediately prior to the effective date of the final regulations. [Treas. Reg. § 1.415(a)-1(g)(4)]
The limits apply in aggregate to all defined benefit plans that have ever been maintained by an employer (as defined by IRC Sections 414(b), (c), & (m) and modified by IRC Section 415(h) to reduce the percentage of control from at least 80 percent to more than 50 percent, except for purposes of determining whether two or more organizations are a brother-sister group of trades or businesses under common control under Treasury Regulations Section 1.414(c)-2(c)). [Treas. Reg. § 1.415(a)-1(f)(4)] If a plan is aggregated with another plan, a participant's benefits are not counted more than once in determining the participant's aggregate annual benefit. Also, benefits transferred from one plan to another plan otherwise required to be taken into account when determining if the transferor plan satisfies the dollar and compensation limits, are not treated as being provided under the transferor plan, because the transferred benefits will be taken into account by the transferor plan when it is aggregated with the transferee plan. [Treas. Reg. § 1.415(f)-1]
Interim rules provide that the limits must be satisfied as of each of multiple annuity starting dates, considering the benefits that have been or will be provided at all of the annuity starting dates. The annual benefit as of a particular annuity starting date, and past and future distributions with respect to a benefit that commenced at another annuity starting date, must be actuarially adjusted. [Treas. Reg. § 1.415(b)-1(b)(1)(iii)]
Employee contributions to a cash balance (or other defined benefit) plan that are not accounted for separately and treated as a defined contribution plan pursuant to IRC Section 414(k) are not considered for purposes of the dollar or compensation limits. More precisely, the plan benefit attributable to such employee contributions, as determined under IRC Section 411(c), is not considered, even if IRC Section 411 does not apply to the plan. [Treas. Reg. §§ 1.415(b)-1(b)(2)(iii), (iv)] If a cash balance plan is a plan is not subject to IRC Section 411, the dollar and compensation limits of IRC Section 415 apply to the distribution of benefits, even though the limits do not apply to the benefit accrued before the benefit is payable. [Treas. Reg. § 1.415(b)-1(a)(6)(iii)]
