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."