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Herman Freitag, CFP®Nov 7, 2022 2:17:58 PM5 min read

Three Considerations For Your Cash Balance Plan With Stocks Down For The Year

Investors are experiencing the worst and most prolonged market downturn since the global financial crisis of 2008 according to data taken from Bloomberg.

With this comes new challenges as many doctors have not yet experienced a significant down year, let alone one while operating a cash balance pension plan. Cash Balance pensions carry additional complications and obligations surrounding how a doctor’s year-end balances align with the actuarial value of the plan. Significant market swings are a fact of life but can potentially have a noteworthy impact on the plan’s overall funding levels. Here we plan to discuss a few considerations for those who may have a Cash Balance Plan with assets falling significantly below the actuarial value of the plan.

First, a quick primer on the actuarial value of a cash balance plan. From a very high level, one can calculate the “plan balance” with two components; a pay credit and an interest credit. The former is tied to compensation for each individual, and the latter is a static interest rate built into the plan document. The overall goal of the investment portfolio is to approximate the interest credits within the plan, with the pay credits being the owner’s yearly funding. Markets are unpredictable. However, with prudent risk management, the investment portfolio of a cash balance plan may satisfy these goals, over time. The important part being that market volatility in the short run cannot be avoided.

In 2022 investors were dealt an additional blow. Even those who made the prudent move of increasing their bond allocations as their plan came closer to maturity were met with disproportionate losses. In the Federal Reserve’s fight against inflation, they have effectuated one of the most aggressive interest rate increase policies since Paul Volker in the 70s via information gathered from the Federal Reserve. This has left the most common bond investment, intermediate bonds, down approximately 10% or more across the board according to data collected from Morningstar. While these losses come with higher yields moving forward, they also mean even some conservative investors are down double digits for the year. Imagine the doctor with a $2 Million dollar Cash Balance plan experiencing 200-300k of losses. They may be quite surprised when presented with a recommended contribution several hundred thousand dollars higher than they expected. So, what should the doctor in this predicament do? Here are three considerations for those faced with losses in their Cash Balance Plans:

1. Consider your time horizon. Cash Balance plans include a 3-5 year smoothing period. Market dips and crashes are generally followed by strong upside performance according to data compiled by JP Morgan. This means that simply holding those assets means that you have a high probability of recouping any market losses within a few years. If you do not plan to terminate your plan in the near future, then you may not need to take immediate action. In fact, contributing a large sum of money while markets are down could potentially mean that when markets rebound your plan could be over-funded, limiting your ability for future contributions.

For those doctors operating relatively new Cash Balance plans, there are many years ahead where micro adjustments in funding can bring you to a desired level. Additionally, your investment balance may not be large enough for market volatility to significantly impact the contribution recommendations. Consult your advisor to ensure you are still on track. In many instances, no action at all is necessary due to the length of time left for a plan to meet its funding goals.

2. Examine options for lowering your next year’s funding. For most doctors, their salary is the largest driver of plan funding levels. They can influence their funding obligations by adjusting their salary up or down in a given year, however, you will want to work with your CPA and advisor to understand any impact this strategy can have. The next option would be freezing plan contributions for a period. While it will not impact the immediate status of the plan, this does stop new contribution credits from being accrued, which can give a doctor time to catch the plan back up to their desired funding levels. Lastly, they can work with their TPA to examine adjusting the benefits formula. Perhaps lowering the percentage of salary benefit will yield lower contribution needs; this should be weighed heavily as frequently adjusting your plan’s benefits formula can potentially cause IRS scrutiny.

3. Consider the real-world impact of closing an underfunded plan. It is important to understand that with any cash balance plan staff will receive their on-paper cash balance when a plan is closed, even if that plan is underfunded. With a cash balance plan, the overall “paper value” of the plan is a combination of each staff member’s balance. With some plans the doctor owns 90% or more of the plan assets, so even in the aforementioned $2 million dollar plan, the staff balances may only be 100-200k. In the event that the account funding is short the actuarial, or paper value of the plan, then the staff receive their full balances, and the owner receives what is left.

However, if one thinks of a cash balance plan as another market-based savings vehicle for a doctor, that happens to come with a fixed cost of staff contribution, then this is not as much of a concern. When closing a plan one can roll their balance right in to an IRA at current market levels, and the only adverse effect is that staff may have gotten a slightly higher percentage of the overall portfolio. With many cash balance plans having under 10% staff costs, an extra percent or so going to staff is not necessarily a poor outcome.

That said, if your staff balances are a significant portion of the overall account then perhaps this philosophy would be a less-than-ideal approach to administering a cash balance plan.

To conclude, markets falling is never a delightful experience, especially in today’s environment with bond funds also experiencing significant losses, but for those operating Cash Balance pensions, there is no need to worry, as there are multiple options available with the intent to attempt to achieve a desirable outcome even in the face of moderate market losses. It’s important to note that Cash Balance assets should not generally be managed aggressively, but even moderate to conservative accounts may experience downturns. If you are operating a cash balance plan, and encountering a situation where your plan assets may be falling short of the funding stated on paper it’s important to work with both a qualified advisor and third-party administrator to ensure you have an effective strategy in place.

Herman Freitag, CFP®

Herman is a Wealth Advisor with CI Brightworth. He graduated with a degree in Marketing and a master's degree in Business Administration from the University of New Orleans.