SECURE 2.0 can help revive corporate defined benefit plans

Providing viable lifetime income options to their retiring employees has become an elusive goal for employers who have moved away from offering defined benefit plans in favor of 401(k) and other defined contribution (DC) plans.  Offering qualified longevity annuities (QLACs), which involves purchases from an insurer, is one possible avenue to provide lifetime income, especially with the improvements included in SECURE 2.0.  However, given the lackluster history of QLACs, that approach still may not be a satisfactory solution.

A one-sentence technical change in SECURE 2.0 has the potential to accomplish that objective but without involving third party insurers.  The provision is found in Section 348 in Title III, Simplification and Clarification of Retirement Plan Rules, entitled CASH BALANCE.  The law directs the sentence to be added to Section 411(b) of the Internal Revenue Code (and the corresponding ERISA section).  In essence, it clarifies how the so-called “accrual rules” – often referred to as the “anti-backloading rules” – apply to a cash balance plan that credits interest using a variable basis (i.e., anything other than a fixed rate such as 5%).  The language states that in performing an anti-backloading test, a reasonable rate not to exceed 6%, should be used in projecting cash balance benefits to normal retirement age.  Previously the IRS interpreted the law to require that the current interest rate at the time a test is performed be assumed to remain unchanged, no matter how anomalous that rate might be.

This law change builds on the cash balance provisions in the Pension Protection Act of 2006 (“PPA 2006).  PPA 2006 cleared up some legal uncertainties for cash balance plans and provided a roadmap for employers to adopt interest credit bases that track the actual rates of return on specified assets.  Some of the acceptable bases to credit interest in these “market-return” cash balance plans are the returns on all or a designated portion of the plan’s own assets and the returns on one or more specified mutual funds.  Before PPA 2006, IRS provided guidance only for plans that credit interest using either a fixed rate (e.g., 5%) or rates that vary under one of the bases listed in the guidance, principally the rates on a Treasury security (e.g., 30-year Treasury bonds).

Cash balance plans that credited variable interest but not market-returns on actual assets, e.g., rates on 30-year Treasury bonds, had a way to get around the adverse impact caused by the IRS interpretation of the anti-backloading rules.  They did so by including an annual fixed minimum interest crediting rate (e.g., 4%).  However, market-return cash balance plans cannot do so (and would not want to do so even if they could), because that would result in interest credits that exceed market rates of return, which is forbidden under the 2006 PPA.

For example, consider a cash balance plan that grants variable interest credits based on 30-year Treasury bond rates.  This plan could not provide pay credit rates that begin at 3% of pay, rise to 4% at 10 years of service and to 5% for years of service over 20, without introducing an annual minimum interest rate of at least 2.1%.  The same pay credit scale could not be used in a market-return cash balance plan because the 2.1% annual minimum (or any other annual minimum) would cause the plan’s interest credits to be impermissible.

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Thus, this one-sentence in SECURE 2.0 opens the door for employers to adopt (or convert their existing cash balance plans) to market-return cash balance plans, without a minimum fixed rate, and with the opportunity to have a scale of pay credits that materially increase by age or service.

Better lifetime income options elected by participants

But how can this result in more and better lifetime income options being elected by plan participants in employer sponsored plans?  After all, even if retiring employees are covered in a cash balance plan, isn’t it true that experience shows that the vast majority of participants elect lump sums, not annuities?

In responding to these questions, it is important to bear in mind that cash balance plans are defined benefit plans and therefore must offer lifetime income forms; and a life annuity (or joint and surviving spouse annuity) is the default form.  When employees elect such lifetime income forms in an ongoing cash balance plan, almost always the payments are made directly from the plan’s trust rather than through the purchase of an insured annuity, thus making it very easy for a participant to elect and receive an annuity.  Through effective plan design and employee communication, market-return cash balance plans can provide life annuities that will be attractive to participants and that will make it much more likely for them to elect (as compared to often complex and expensive insured annuities offered in a defined contribution plan).  Moreover, plan sponsors who have been experiencing financial volatility with their non-market-return cash balance plans now have an alternative that would allow an easy conversion to a market-return design with more stable and predictable financial outcomes.

Employers that sponsor cash balance plans with ongoing or even frozen benefit credits should examine how this one-sentence could present a new and better path to providing SECURE lifetime retirement income in a way that will help their employee recruitment and retention needs. More design flexibility, more stable and predictable contributions and costs, and more legal certainty sets the stage for more employers to consider a market-return cash balance plan, in combination with a defined contribution plan.

Larry Sher is a partner at October Three and a leader. He has over 40 years of experience primarily in the design, financial, and compliance issues involving defined benefit plans, specializing in innovative plans including cash balance plans.