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.