'Benefit-Focused' Retirement Plans-WlthMgt

October 2, 2009

Qualified retirement plans are an excellent way to generate tax deductions, grow money tax-deferred for retirement and protect assets from unjust lawsuits. However, even those advantages can't motivate everybody-especially, say, wealthy individuals running their own companies. If you're worth half a billion dollars, for instance, a $20,000 personal deduction isn't going to motivate you to start a retirement plan for your family office or private equity firm. Even if you do, it might be "top heavy"-as the owner you're unable to contribute very much to the plan.

When there is no personal financial benefit for them, many affluent individuals give up on using these plans altogether. That goes for many hedge fund managers, single-family offices, family-run businesses and private equity managers.

In a recent survey of 311 hedge fund managers (whose assets under management ranged from $100 million to $500 million), only about 16% had qualified retirement plans (Figure 1). Three-quarters of those who didn't say there was not enough personal financial benefit for them (Exhibit 2). Managing partners at private equity firms stay out for similar reasons (see Exhibits 3 and 4), as do celebrities, single-family offices and wealthy families running their own businesses, all of whom have seen little financial advantage in it-at least until now.

The Benefit-Focused Retirement Plan
Things changed with the Pension Protection Act of 2006, which took effect in 2008. The act changed the rules for funding defined benefit plans and among other things it brought to life something we have dubbed the "benefit-focused plan." There are already many qualified plan types out there, most of them benefiting company employees, but the new law has spawned something different through various mechanisms backed by IRS letters of determination and legal opinion. In essence, it has created a new type of plan that for the first time offers benefits for successful, wealthy business owners who might otherwise stay away. The changes have been little talked about, but even now some managers in the hedge fund and private equity world are starting to take advantage of it.

The benefit-focused plan enables key employees, principals and their families to benefit most from the invested money in the plan. Moreover, within governmental guidelines, these principals have the power to designate who else participates in the plan at their companies. All in all, it allows them to further derive the largest corporate tax benefit of any qualified retirement plan.

But one of the most important aspects of the new plan is that it can as much as triple corporate tax deductions when compared to a traditional defined benefit retirement plan, offering the wealthy individual who owns the company larger potential deductions than he or she could find in any other type of retirement setup. This can allow companies the highest possible deduction amounts of all qualified retirement plans out there, making it very useful in adroit income tax planning.

The benefit-focused plan also creates great business planning and estate planning advantages. If the owners die, the benefits can transfer to their spouses and heirs over their lifetime. And part of the reason is the life insurance component in the plan.

In a benefit-focused retirement plan, the owner purchases life insurance as part of the funding mechanism for the plan structure. Not only does he then benefit by getting life insurance using pretax dollars, but the proceeds of the insurance when he dies are income tax free and can even be estate tax free. This benefit proves useful in succession and estate planning.

Because the benefit-focused retirement plan is a qualified plan, the plan assets are protected from creditors and litigants. Furthermore, the insurance component can be used in a buy/sell agreement, so if your business partner dies, you can use insurance proceeds to buy his equity in the company.

To get a better feel for the power of benefit-focused retirement plans, let's look at a few examples. In 2009, with a defined benefit plan, the most a plan owner can receive is $16,250 per month for his or her lifetime once retired (which is the payout to participants in the following examples). As noted, with benefit-focused retirement plans, this benefit can apply to heirs if the owner dies.

Example #1: Hedge Fund Managers. Among our clients is a husband-and-wife team that manages a hedge fund. They have six additional employees-three analysts, two portfolio managers and a COO/CFO. Under a 401(k) plan, they would have only been able to put about $30,000 into their plan each year. Their contributions would be further curbed if their contributions as senior managers had made the plan too "top heavy," when placed alongside those of the other employees. In this scenario the benefit-focused retirement plan initially places all the benefits in their hands, giving them alone 100% of the benefits of the plan. They also were able to take a corporate tax deduction of about $750,000 in the first year. Meanwhile, there's a life insurance policy that pays one spouse around $1.7 million when the other passes. And this life insurance can be part of the couple's overall estate plan and go toward paying a portion of the estate taxes they owe.

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