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Cash balance plans are gaining popularity. Matt Sommer, Head of Janus Henderson’s Specialist Consulting Group, explains what advisors need to know about using these plans to help highly compensated clients sustain their desired level of income in retirement.
When planning for retirement, a common goal is to maintain the standard of living one has grown accustomed to. Many investors are able to accomplish this through defined contribution plans such as 401(k)s. But for certain professionals who have earned high salaries throughout their working years, replicating that level of income in retirement can be a challenge.
Contribution limits on traditional 401(k) plans pose a significant obstacle to high earners whose savings may have fallen short as they near retirement. For 2023, the IRS has limited combined employee/employer contributions to $66,000 ($73,500 for participants 50 or older). Given those limits, highly compensated individuals may not be able to make the sizable contributions that would allow them to generate a similar level of income in retirement.
Enter the cash balance plan (CBP). A CBP is a type of defined benefit retirement plan that defines the promised benefit in terms of a stated account balance, similar to defined contribution plans. But one advantage of CBPs is that they allow participants to accelerate retirement savings beyond what they could put into a 401(k). Furthermore, contributions are pre-tax, making the plans attractive for those in higher income tax brackets.
Cash balance retirement plans are the fastest-growing segment of the U.S. retirement plan market, with more than $1 trillion in assets.1 CBPs’ popularity has particularly grown in the “micro market,” defined as plans with nine or fewer participants. According to FuturePlan’s 2023 National Cash Balance Research Report, 61% of all cash balance plans are in the micro market and two-thirds of plans have assets under $1,000,000.2
These plans are particularly popular with older, highly compensated business owners who are interested in making contributions greater than the present 401(k) profit sharing limits referenced above. When structured properly, CBP contributions can easily dwarf these amounts. And because contribution limits increase with age, the plans can be especially advantageous for older investors who are on the home stretch to retirement.
Annual contributions to a CBP are determined by an actuary, but the basic idea is that annual contributions plus earnings should replace a predetermined percentage of a participant’s income in retirement. Furthermore, whereas 401(k) participants may direct their own investments and therefore bear the risks and rewards of their choices, the investments in CBPs are managed by the employer (or an investment manager appointed by the employer), who bears the risks.
One interesting feature of CBPs is the interest crediting rate (IRC). The IRC is established in the plan document and can be thought of the plan’s targeted rate of return. In general, performance that falls short of the IRC may have to be made up with greater contributions in future years, while performance greater than the IRC may mean lower contributions down the road.
According to FuturePlan’s 2023 survey, 84.5% of micro plans have adopted a fixed rate ranging from 1%-6%, with rates between 4%-5% being most common.3
When interest rates were close to 0%, many financial advisors shifted cash balance portfolios to equities to achieve those rates. However, it may be time for advisors to consider de-risking cash balance plans and locking in yields that match the plan’s IRC. Today’s environment of rising rates makes a target interest rate of 4%-5% attainable through fixed income. Strategies that invest in high-quality fixed income assets may be an appropriate choice for more risk-averse clients nearing retirement who are focused on capital preservation.
Of course, advisors still need to manage duration, credit, and other risks associated with fixed income, so a diversified portfolio is still the recommended approach.
For advisors seeking to help highly compensated clients sustain their desired level of income in retirement, a CBP is a tool worth considering. However, it’s important to understand the somewhat counterintuitive way in which the plan’s investments are managed: Unlike a 401(k), the focus with a CBP is on the contributions, not the returns. Consistency of annual contribution amounts – and annual tax deductions – is one of the keys to ensuring a smooth participant experience.
Diversification neither assures a profit nor eliminates the risk of experiencing investment losses.
Duration measures a bond price’s sensitivity to changes in interest rates. The longer a bond’s duration, the higher its sensitivity to changes in interest rates and vice versa.
1 “Cash Balance Plans Gain in Popularity,” Plan Sponsor, March 2023.
2 “National Cash Balance Research Report,” FuturePlan by Ascensus, March 2023.