With SECURE 2.0, the Cash Balance DB Plan May Be Back

There may be renewed interest from companies in starting defined benefit plans and even opening up frozen plans that are not accepting new participants, according to panelists at the PLANADVISER/PLANSPONSOR DB Summit held last week.

Steve Mendelsohn, pension director at Zenith American Solutions Inc., moderated the Alternative DB Plan Designs session, in which experts discussed both cash balance plans and variable benefit plans.

A DB cash balance plan is an account paid into by the employer, yet operating similarly to a 401(k) plan for participants; it also gives retiring or terminated employees the option of a lifetime income annuity or lump-sum payout. Thanks to the return of regulation that allows for plan payouts to align with employee tenure, companies may be interested in starting DB cash balance plans again, said John Lowell, a partner and consulting actuary at October Three Consulting LLC.

Recently, many organizations were either freezing or skipping the DB plan option because “they couldn’t stand the volatility” that went into managing them due to market fluctuations, Lowell explained on the webinar. They also were struggling with the advantages of it, because regulation did not allow them to vary the retirement income check based on tenure.

“It’s very technical, but essentially [regulators] said almost any cash balance design you have with a variable interest crediting rate has to have back-pay credits,” Lowell said. “That means that if you give a 5% pay credit to a person who’s 20 years old, you have to give a 5% pay credit to a person who’s 60 years old. You can’t have any variability.”

Past cash balance plans tended to have graded pay credits. To get back to that more attractive option, Lowell said, industry players were told they needed a Congressional fix to allow for graded pay credits.

Thank You, Congress

That fix came with the passage of the SECURE 2.0 of 2022 in December 2022. It allowed plan sponsors to assume an interest credit that is a “reasonable” rate of return, provided it does not exceed 6%.

“What that does is now say that participants can get a market rate of return on a basket of investments that they can get invest in, in just the regular world or in their defined contribution plan,” Lowell said.

As a plan sponsor, if you know what the rates of return are going to be, you can hedge them by making the same or similar investments, he explained. This is key, because a sponsor’s assets and liabilities can track each other, essentially de-risking the plan and providing costs that are at least as stable and predictable as a 401(k) plan or a profit-sharing plan.

“There’s really no difference from an employer’s standpoint in terms of cash flow perspective,” Lowell said. “But from the employee standpoint, there’s an awful lot you get. … You get your choice of a lump sum in almost all plans, or an annuity at fair prices.”

Variable Benefit Plans

Another trend in the DB space is what moderator Mendelsohn called variable pension plans, which reduce risk to the funding sponsor. These types of plans have “struck a chord with Taft-Hartley” trustees, or multiemployer benefit trusts, he said.

There are two types of variable plans, said Richard Hudson, a consulting actuary at First Actuarial Consulting Inc. In one, the participant’s end-benefit fluctuates depending on market returns.

These type of plans “generally show their benefit in terms of shares on the plan,” Hudson said. “A benefit formula might be $100 per month per years of service for one person to pay whatever it might be; you take that benefit, and you convert it to a number of shares.”

Those share values are going to increase and decrease each year with the investment performance trust fund, Hudson explained. One concern is that if a participant retires and there is a market downturn, they might lose 20% of their benefit. To offset that, some plans set up a reserve to protect retirees from a downturn. Either way, this market-tied defined benefit may be a challenge for sponsors to manage due to market fluctuation.

Scenario Two

In the second variable-plan scenario, the employee will get a fixed contribution—what changes are the future accruals within the trust, Hudson said.

“The general idea of this plan is to provide the employer with a fixed contribution,” he explained. This plan is “not subject to volatility and ensures that the contribution is sufficient by adjusting for future benefits. It then allocates those dollars between newer pools and underfunding in the plan and paying that off.”

In a static pension plan, Hudson said, it is hard to determine what the next 10 or 20 years are going to be. With variable benefits, the result is to reverse that setup to make the contributions stable, while the benefit formulas adjust over time.

That setup “will absorb the impact of gains and losses,” Hudson said. “If the plan becomes underfunded, you have more contribution dollars that are needed to shore up the fund, so less money is available for benefits, and it will decrease the accrual. If the plan becomes overfunded, you have more money than you need, and [you]’re going to amortize that money back into new benefits by increasing the accrual.”

There are drawbacks to the plan, according to Hudson. That includes the plan needing to be designed correctly without knowing the future of the investment market, as well as some gray areas around how the IRS values variable benefit plans.

In the end, sponsors can go back and forth while weighing benefits of the two plan designs, Hudson said, “but ultimately, the deciding factor is always going to be what can we communicate to our participants. And what are they going to understand. That becomes the deciding factor as to which plan you’re going to deal with long term.”