Interest Credit Rate in a Cash Balance Plan

[Gary]

The active interest credit is the rate that is applied to the hypothetical account balance for actives and the inactive interest credit is the rate that is applied to inactives. This has nothing to do with pay based credits.

[Gary]

A plan uses an inactive interest credit of the average for a 12 month period of the 1 year treasury and the 30 year treasury. They use an active interest credit of the inactive rate + 2.25%.

Any comments w/r to the legality of these rates and any specific violations, if any?

[Guest Don N]

Just want to understand your terminology first so that we start on the same page; is the active credit % the same as the "pay" credit % and the inactive % the same as the rate that's applied to the hypothetical account balance ?

[Guest Steve C]

I'm an actuary, not an attorney, but I don't see any immediate legal problems here.

You should note that the benefit accrual pattern is affected when the higher rate is contingent on future service. That could cause problems with benefit accrual rules of IRC 411(B)(1), which limit the "back-loading" of accruals. I normally wouldn't expect a problem to materialize, since cash balance plans tend to be heavily front loaded. This could become an issue, though, if the plan uses a graded schedule of pay credits.

In Notice 96-8, the IRS suggests that a "backloaded interest credit plan" will not satisfy the accrual rules, but I believe that they were contemplating a plan that credits zero interest when not actively employed.

[Guest]

I agree with IRC 401. Crediting a lower rate of interest to terminated participants creates a number of problems under the qualification rules. This is a well-known "no-no" in the cash balance world. Besides the problems mentioned by IRC 401, you would have fundamental backloading issues.

[IRC401]

I see two possilbe problems:

1. If (A) you are using a general test, and(B) you use the active rate for the (a)(4)calculation, a participant who terminated could argue that at the time the test was run he earned an accrued benefit which included the active interest rate until the testing age, and reducing the interest rate upon termination is an impermissible reduction in his accrued benefit.

2. For lump-sum calculations, don't you need to project "accounts" forward using the plan interest rate and then discount back using the GATT rate. It seems to me that you could end up with some screwy results.

[Guest Steve C]

hmmm...I have to disagree, at least in part.

I think it's clear that the interest credit is considered part of the the accrued benefit only to the extent that it is not conditioned on future service (see the discussion of frontloaded and backloaded interest credit plans in Notice 96-8). This design has a mixture of frontloaded and backloaded components, with the "inactive" rate frontloaded and the additional 2.25% backloaded.

That being the case, the accrued benefit here recognizes future accumulation at only the "inactive" rate. The additional 2.25% interest credit (on the entire balance) is accrued as each year of service is completed.

1. As for the general test, how likely is it that a participant would make a non-frivolous benefit claim based on testing methodology? Beyond that, you need to consider the validity of using the "active rate" as part of the test. I'd think that you would use the inactive rate under either the Annual Method or Accrued to Date. The active rate would be appropriate only under the Projected Method, which anticipates future service.

2. I agree that lump sum results may be a bit screwy. It's unlikely that the lump sums will match reported cash balance amounts, which could raise some questions.

3. Although this design does include a bit of backloading, it doesn't appear to be enough to cause a problem with the accrual rules. The frontloading that arises from the inactive rate should allow the plan to satisfy the 133% rule, unless a creative pay credit (e.g., a graded rate) is used.