We’ve been waiting quite a while for some official guidance on many of the technical issues involved with cash balance and other hybrid retirement plans. Last week we received final regulations for some issues, and proposed regulations for others. This post focuses on what constitutes a Market Rate of Return.
A brief recap: typically a cash balance benefit consists of annual Principal Credits (aka Pay Credits) to a participant’s account (e.g., a credit equal to 2% of pay) plus an annual Interest Credit on the accumulated balance. One of the rules of Interest Credit rates is that, for statutory hybrid plans, they cannot be greater than a Market Rate of Return.
The final and proposed regulations provide many technical details regarding the Market Rate of Return ceiling. We can’t summarize all of the minutiae in this blog post, but below are some of the final and proposed Interest Credit rates which the IRS would not consider to be exceeding the Market Rate of Return threshold.
- Hybrid plans may define the Interest Credit rate to be equal to the rate of return on plan assets if the plan’s assets are diversified. In this case, diversified has the same definition as 404(a)(1)(C) of ERISA.
- Interest Credits may be defined as the rate of return on a section 851 Regulated Investment Company (i.e., a mutual fund) that is reasonably expected to not be significantly more volatile than the overall US equity market or a similarly broad international equities market.
- There are certain cases where the Interest Credit can be based on the greater of two rates:
– An annual “greater of” rate of up to 4.0% can be used if the comparison rate is equal to the rate of return on long-term investment grade bonds or one of the other safe harbor rates (e.g., 30-yr. Treasury).
– A cumulative “greater of” rate of up to 3% (compounded until the annuity starting date) can be used if the comparison rate is an equity-based rate.
- A fixed 5.0% Interest Credit rate is a safe-harbor rate and a plan amendment which changes the Interest Credit rate from the third segment rate to a fixed 5.0% would not violate the 411(d)(6) benefit cutback rule.
All of this makes cash balance investments sound really easy, doesn’t it? Not so fast. A statutory hybrid plan must also comply with the “preservation of capital” requirement: a participant’s final payout can’t be less than the total of all their Principal Credits. Put another way, cumulative Interest Credits can’t be negative. That means, for example, that you could set the Interest Credits equal to the S&P 500 and buy shares of a corresponding index fund. But, you would have to shore up cumulative negative returns for any participants who leave in a down market.
There’s a lot of important stuff in the final and proposed hybrid plan regulations, and the Market Rate of Return clarifications are just a start. We’ll continue to add more plain-language analysis of these rules over the coming days. In the meantime, you can follow the link to our cash balance FAQ’s.