Cash-balance plans let successful business owners save more.
Advisor John Stephens had been mulling a
cash-balance plan for a doctor group last summer even before the
Pension Protection Act of 2006 was signed. Stephens knew the physicians
would like the fact that the assets in this qualified plan are shielded
from creditors under ERISA. And it would certainly allow them to
realize their chief objective: to defer more for retirement on a
tax-deferred basis than permitted under their defined-contribution
plan, currently $45,000, or for those at least age 50, $50,000.
Then along came the pension act with several
favorable changes for these plans and suddenly, the doctors could put
away even more than the planner had initially thought. "It made the
numbers look a little bit better," says Stephens, a partner at TCI
Wealth Management in Tucson, Ariz.
For business owners with the goal of maximizing tax-deferred retirement
savings, a cash-balance plan is often just the ticket. "The numbers can
be breathtaking," says Minneapolis consulting actuary Jim Van Iwaarden,
who has seen owners sock away as much as $200,000 annually.
Recommending a solution like that to a client with tax woes can do
wonders for the relationship, not to mention help you gather new,
sticky assets.
"These are the owners' long-term dollars," says
Charles Langowski of Advanced Capital Group in Minneapolis,
full-service retirement-plan consultants who manage cash-balance money.
"We see a large market for it, especially with medical practices, law
firms and other professional groups." Count advisory shops in that
number: Some have gone cash-balance.
Yet others in the advisory community naively
associate the plans exclusively with large public companies, probably
because of recent high-profile lawsuits involving plans at IBM and J.P.
Morgan Chase. In these and other cases, courts have ruled
inconsistently about whether extant cash-balance plans are
age-discriminatory. Nevertheless, use among small private enterprises
is expected to flower. Why?
Because the pension act laid out requirements that
new plans could follow to avoid age discrimination. It also eliminated
the whipsaw calculation, which previously had put plan sponsors at risk
of having to pay out larger-than-expected, lump-sum benefits. Equally
important, the legislation established, going forward, how to convert a
traditional pension into a cash-balance plan. Cutting-edge advisors
should therefore know about this odd duck, and managing its assets.
You'll need to work with an actuary, of course. Just
be sure to team with somebody experienced in the complexities of
cash-balance plan design and administration. Avoid novices suddenly
flocking to the area.
Statutory Hybrid Plan
The Internal Revenue Service calls cash balance a
hybrid. It's basically a defined-benefit plan with a benefit expressed
in terms of an account, similar to a defined-contribution plan. In
actuality, the cash-balance plan is not subdivided into individual
participant accounts.
Here's how it works. Each year, the employer
guarantees the participant: 1) a contribution, based on a formula
stated in the plan for that participant's class, plus 2) an interest
credit that can not exceed a "market rate of return," a pension-act
term of art that the IRS had not clarified as of this writing.
Participants fully vest within three years. When they leave or retire,
vested money is theirs to take in a lump sum or annuity.
Different participant groups may receive different
contributions and get different benefits under the plan, so long as IRS
nondiscrimination rules are complied with. There may be multiple
classes of owners and key employees with contributions and benefits
differing among the classes, along with multiple classes of other
participating employees. The possibilities are virtually infinite, says
Van Iwaarden, although there is a participation requirement.
At least the smaller of 50 individuals or 40% of all
those eligible to participate must be covered. "For example, if the
participation requirement is age 21 with a year of service and a
company has 12 employees, ten with a year of service, then at least
four (40% times ten eligible employees) must be in the cash-balance
plan," Van Iwaarden says.
All four could be owners, with the right set of
circumstances. Or say there's a large law firm with 50 or more
partners. Their plan could cover only the partners.
Regardless of who is covered, advisors report that
everyone involved appreciates the easy-to-understand account-balance
concept, as compared to the usual DB-plan mumbo-jumbo about
career-average pay and coordination with Social Security.
Better Than Traditional Pensions
Part of what makes cash-balance plans so attractive
to multi-owner organizations such as professional practices is that the
partners don't subsidize one another-that is, pay for one another's
benefits-which can sometimes happen with a traditional pension, Van
Iwaarden says. An owner who puts $100,000 of gross pay into a
cash-balance plan will receive in benefits $100,000 plus the interest
credits. Such a direct linkage between what goes into the plan and the
benefit that comes out doesn't always materialize with a traditional
pension, particularly when the owners differ along variables such as
age, tenure or ownership percentage, he says.
A second attractive feature is potentially much less
contribution volatility than has historically and famously plagued
traditional pensions. If the cash-balance plan assets earn the
interest-crediting rate precisely, the plan will not become
underfunded-in other words, the assets will equal the obligations to
pensioners-and the employer's contribution can stay constant. Another
factor helping to steady the contribution is that it's less dependent
upon an interest-rate-sensitive present-value calculation than the
contribution to a traditional pension is, says Van Iwaarden.
Profile Of Candidates
What business is ripe for this plan? A successful
one with predictable cash flows that are likely to continue. You don't
use it when high business profits are a one-year deal. IRS guidelines
require a pension plan, even a hybrid one, to be "permanent." That
normally means funding it for a minimum of five years, actuaries say.
During that time, the owners must be willing to
spend for their workers' benefit. Younger employees in the cash-balance
plan, and a low ratio of employees to owners, help keep the
contribution down. But even so, in order for the IRS to feel like the
plan doesn't unduly favor highly compensated employees, it usually must
be operated in tandem with a reasonably generous defined-contribution
profit-sharing plan that covers the rank and file.
"For example, contributing 7.5% of pay to profit-sharing for workers
allows you to cross-test, which facilitates passing the IRS
nondiscrimination testing," says Van Iwaarden. On the other hand, the
arrangement could be designed to allow the actuary to determine each
year, based on all the participants' ages and compensation, the minimum
profit-sharing contribution needed to pass the tests. Either way, there
is a cost to the owners. (As an aside, it was the pension act's
improvement to a limit that had constrained DC-DB combo plans that
enabled the physician group in the case mentioned at the outset to
stash more for themselves.)
The downfall to cash balance? "Complexity, really,"
which creates additional cost, says benefits attorney Joseph S. Adams,
a partner at McDermott Will & Emery in Chicago. There is no IRS
prototype plan document, no off-the-shelf product that's available, he
notes. Each plan needs to be custom drafted-not a trivial expense.
Annual operating costs tend to run on the high side, too.
Investing The Plan Assets
The participants' interest credit is set as
generously as the employer feels appropriate, within IRS limits. "But
remember, it's really a defined-benefit plan behind the scenes," Adams
says. "There doesn't necessarily have to be a connection between the
rate you're promising participants and the rate the pool of money is
actually earning." With participants' benefits guaranteed, the employer
bears the investment risk-and likewise enjoys any outperformance. Which
raises an important question for the plan's investment advisor.
Do you attempt to match the interest-crediting rate,
so that the employer's contribution doesn't fluctuate? Or do you try to
beat it? Because if the assets earn more than the rate participants
get, the company can make a smaller contribution the following year.
Some owners-patently aggressive law firms, for
instance-expect the advisor to top the guaranteed rate and save them
money. But many do not. "Our clients want us to come as close to the
bogey as we can. They want certainty in their funding," says Langowski,
the Minneapolis money manager. His firm targets returning within 25
basis points of the plan's interest-crediting rate, plus or minus. "If
you consistently lag by more than that for a few years, the partners
are going to have to kick in some capital. Any shortfall comes out of
their pockets," Langowski says.
Stephens focuses on dampening the downside draft.
His cash-balance portfolios are 50% fixed-income and 50% diversified
equities, a mix he feels has only a small chance of performing very
poorly yet has been beating his plans' crediting rates. "You want the
portfolio to do well," he says. "You also want to avoid significantly
underperforming" the interest-crediting rate so that the plan doesn't
become underfunded and ratchet up the sponsor's contribution.
That's a critical point. "Unlike 401(k) or other
money invested for growth with accompanying volatility, you don't want
volatility here," says Stephens. "Because the cash-balance plan is a
pooled account, the trustees and the advisor have fiduciary
responsibility for every single participant's money. The investment
policy statement needs to be very clear about that, as do the trustees,
and the portfolio has to be managed cognizant of that."