For many businesses, sponsoring a traditional pension plan has become too much of a burden on their bottom line. The costs, related to both administrative and benefits, have left them in search of a more affordable option.
Your clients may be facing this exact problem. How can they rein in costs while still providing for their employees’ futures? The solution may be to convert their traditional pension plans into cash balance plans.
Differences Between Traditional Pension Plans And Cash Balance Plans
Converting plans isn’t as hard as one might expect because both are defined-benefit plans. Both kinds of plans promise a set payout to participants upon retirement and are fully funded by the employer.
The big difference between the plans is how benefits are calculated. Traditional pension plans calculate benefits based on the employee’s length of service and the average of their salary during the end of their employment.
The benefit formula for a cash balance plan uses different factors. It consists of a certain percentage of annual salary, such as 5%, that grows by a set interest rate. These amounts are placed into an “account” that determines the employee’s benefit upon retirement.
Usually, the benefits are lower under a cash balance plan and therefore cost the employer less.
How To Convert A Plan
Because they are the same type of plan, traditional pension plans and cash balance plans are subject to the same rules and regulations. This makes it much simpler to do a conversion than to change from a pension plan to a defined-contribution plan, such as a 401(k).
To convert, a plan sponsor must simply amend their current plan and benefit formula. The amendment must be in accordance with the plan documents and all applicable laws.
Legal Requirements When Converting Plans
In order to protect plan participants, there are certain legal requirements when converting plans. Plan amendments can change future benefits, but not benefits previously accrued.
Participants must receive their full pre-amendment benefit in addition to the new cash-balance benefits. There cannot be a “wear away” period in which the participant does not accrue additional benefits. Under a cash balance plan, all benefits must be fully vested after 3 years of service, even those earned before the amendment. (1)
If the amendment will significantly reduce the rate at which participants earn benefits, advance notification to participants is required. Your client will have to provide this at least 45 days prior to amending the plan. Once the plan is amended, they must provide all participants with a Summary of Material Modifications to the plan or a revised Summary Plan Description. (2)
Plan sponsors are also prohibited from age discrimination. The Age Discrimination in Employment Act (ADEA) states that an employer is required to provide sufficient information for a knowledgeable decision when asking employees to sign a waiver of rights and claims when choosing between plans. Most of the time, the employee must have at least 21 days to sign the waiver and 7 days to revoke the agreement. (3)
Options When Converting Plans
Converting a traditional pension plan to a cash balance plan doesn’t have to be an all-or-nothing deal. Plan sponsors have several options regarding how to apply the conversion.
The plan sponsor can allow employees to remain under the old formula while restricting new hires to the new formula. They can also permit certain employees who have reached a specific length of service or age to stay with the old formula.
Or, they can make a clean break and provide no choice for employees. They can completely replace the old formula and apply the new one to all plan participants. There is a certain degree of flexibility for plan sponsors, as long as they adhere to the legal requirements mentioned above and don’t attempt to reduce previously earned benefits. (4)
How I Can Help
Though converting to a cash balance plan from a traditional pension plan is pretty straightforward, when it comes to ERISA compliance, nothing is as simple as it seems. If your clients are considering a plan conversion, they need to make sure they do things the right way to avoid jeopardizing the qualified status of their plan.
The best way to ensure a smooth, legal transition is to hire a pension plan consultant. I am a pensions specialist and can help your clients through every step of the process, from developing formulas to notifying participants. Email me today at info@ff401k.com for more information on how I can help your clients adjust their pension plan to be more affordable and sustainable in the years to come.
About Kenny Phan
Kenny Phan is a Managing Partner at FinancialFocus Retirement Plan Services, a 3(16) fiduciary. He works as a pension specialist who partners with financial professionals to design and implement pension plans. His area of expertise is customized defined benefit, defined contribution, and 401(k) plans. Serving financial advisors and businesses in the greater Phoenix area, he is supported by FinancialFocus Retirement Plan Services. Together, they provide comprehensive plan design consultation, administration, document installation, compliance testing, as well as IRS and DOL reporting for qualified retirement plans.
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(4) https://www.dol.gov/agencies/ebsa/about-ebsa/our-activities/resource-center/fact-sheets/cash-balance-pension-plans