A Flexible DB Plan?
Cash balance plans—when used in addition to a 401(k)/profit-sharing plan—can help business owners substantially increase their retirement savings; but the cat isn’t out of the bag—yet.
A majority of advisers still are unaware of some of the changes that were brought about by the Pension Protection Act of 2006 (PPA). The PPA involved many things—one of them being clarification and support for cash balance plans.
Nuts and Bolts
A cash balance plan is a variation of a defined benefit plan; employers (usually the business owners themselves) make a contribution into the plan on the employees’ behalf. However, since these plans also have some of the characteristics of a defined contribution plan, they are frequently called a “hybrid” plan (see Cash Balance Basics).
Because the assets are pooled, the investments usually are made with a conservative bias, with a typical target return ranging from 3% to 7%. Dan Kravitz, President of Kravitz, Inc., which designs, administers and manages retirement plans and specializes in CB plans, says most plans use the 30-year Treasury rate as a safe harbor investment.
As Kravitz explains, cash balance plans can offer highly compensated executives higher contribution limits like traditional defined benefit plans without cost volatility and interest rate risk associated with them. Cash balance plans also offer sponsors and participants portability (assets can be rolled into an Individual Retirement Account) and participants receive annual statements with their account’s “cash balance.”
Selling Points
The main reason a profitable small-business owner would want to use a cash balance plan as a retirement savings vehicle is tax efficiency, says Kravitz. “If your client is fortunate enough to have a ‘problem’ with too much profit, a cash balance plan can offer a solution—pay fewer taxes and save more toward retirement, for both you and your employees,” he explains.
The “profitable” part is key, explains Bruce Henning, a Charlotte, North Carolina-based financial adviser and partner at Retirement & Estate Planning Services. The contribution to a cash balance plan is made entirely by the business owner (or owners), and, if the investment returns toward the contribution amount fall short of what was arranged, the owner must make up the difference.
Steve Lippman, director at Bernstein Global Wealth Management in New York, points to two additional reasons why a cash balance plan may be appealing to a business owner: Like any qualified retirement savings plan, the assets are protected from creditors, and, because a cash balance plan can boost retirement savings, it can help a business owner be better prepared for implementing a succession plan.
The 2011 National Cash Balance Research Report, released by Kravitz, notes a 20% average annual increase in new cash balance plans since 2001, compared with the 3% average annual growth rate in 401(k) plans. Lippman says two years ago his company handled four plans; now, it has 70 and is expecting that number to grow significantly in 2012. Lippman sees three reasons for this rise in popularity of cash balance plans.
One reason is increased investment flexibility; another is enhanced plan design flexibility; but perhaps more than either of those reasons, the rise in cash balance plan creation has been caused by a desire by professionals to accelerate retirement savings. Those in that camp can “choose to do one of three things: work longer, spend less and save more or enhance what they’re currently doing,” says Lippman. Implementing a cash balance plan would be a way to enhance a retirement saving strategy—investing in a tax-deferred account, rather than a taxed account. “This tends to be the most palatable strategy for business owners,” he notes.
Investment Flexibility
In addition to clarity provided by the PPA, cash balance plans have received some favorable legislation from the IRS in recent years. On October 19, 2010, the IRS issued regulations largely eliminating funding issues that prevented some employers from implementing the cash balance plans. Previous guidance allowed several safe-harbor rates including the 30-year Treasury rate and the interest rate on long-term investment-grade corporate bonds.
However, as Kravitz explains, the regulations allow for an “Interest Crediting Rate” (ICR) to equal the “actual rate of return on plan assets,” including both positive and negative returns. This option is allowed as long as the employer chooses diversified investments to minimize the volatility of returns. For example, investing cash balance plan assets in a mix of bonds and equities would be acceptable, while investing exclusively in a sector fund would be unacceptable.
This option will appeal to employers since it minimizes most of the underfunding and overfunding issues, Kravitz says. The challenges of exceeding or falling short of a targeted ICR every year are largely eliminated under this option. However, if the ICR is set to equal the Actual Rate of Return, the “preservation of capital rule” will apply, which is meant to protect the employees’ assets in the plan. The rule says no participant will receive less than the aggregate amount of employer contributions at the time of withdrawal. For example, if a participant received annual employer contributions of $1,000 for three years, but the ICR was negative each year, the account balance would therefore decrease from $3,000 to $2,800. However, if the participant left the company and requested a lump sum payment, the preservation of capital rule applies, so the plan would have to pay out $3,000, even though the account balance was only $2,800.
“The risk lies entirely with the employer and, of course, some small-business owners would not be okay with that,” Henning points out.
Commitment Flexibility
Henning says small-business owners are often concerned that they’re not making enough profit to warrant implementing a cash balance plan.
He says a dentist is a good example. While a dentist can do well for himself, he might not have enough cash left over after paying his salary, his staff’s salary and other operating expenses. However, with the passing of the PPA, small-business owners were granted more of a range in what they must contribute to have a qualified cash balance plan.
The range is dependent on age and on how many years the owner has been contributing to the plan. The older an owner becomes, their minimum contribution amount decreases, so in case they are having less-profitable years as they approach retirement, they can keep more of their profit. Also, if for several years the owner has been contributing the maximum amount, they may be allowed to make a smaller contribution the following year.
“Each plan is different,” says Henning, and because the plans are designed to suit a specific company, they should be designed with the help of an actuary and adviser.
SIDEBAR: Cash Balance Basics
Like a defined benefit plan:
— the benefits are defined by the plan
— the employer makes contributions to the plan based on the same kinds of actuarial assumptions
— the employer is responsible for any shortfall between the value
of the plan and its benefit commitments
— the plans are covered by the Pension Benefit Guaranty Corporation (PBGC), and the employer must pay premiums.
Like a defined contribution plan:
— individual accounts are established and maintained
— employees generally are given account statements showing them the value in their account on a regular basis.
A cash balance plan is unique:
— In establishing and crediting individual accounts with income based on a pre-determined formula/rate, regardless of the actual investment return of the plan
— balances accumulate gradually over an employee’s career.
Cash balance plans tend to:
— Be more valued by younger, more mobile workers
— Be less confusing than traditional defined benefit programs
— Provide a more portable level of pension benefit for a mobile workforce, including those who leave the workforce for periods of time
— Cost less than a comparable defined contribution. —PA
SIDEBAR: Who Is a Good Candidate for Cash Balance Plans?
1) Partners or owners who desire to contribute more than $50,000 a year to their retirement accounts. Many professionals and entrepreneurs neglect their personal retirement savings while they’re building their practice or their company. They often have a need to catch up on years of retirement savings. Adding a cash balance plan allows them to rapidly accelerate savings with pre-tax contributions as high as $100,000 to $220,000, depending on their age.
2) Companies already contributing 3% to 4% to employees, or are at least willing to do so. While cash balance plans often are established for the benefit of key executives and other highly compensated employees, other employees benefit. The plan normally provides a minimum contribution of between 5% and 7.5% of pay for staff in the cash balance plan or a separate profit-sharing 401(k) plan.
3) Companies that have demonstrated consistent profit patterns. Because a cash balance plan is a pension plan with required annual contributions, a consistent cash flow and profit are very important.
4) Partners or owners older than 40 who desire to “catch up” or accelerate their pension savings. Maximum amounts allowed in cash balance plans are age-dependent. The older the participant, the faster they can accelerate their savings.
Source: Kravitz, Inc.