Best of Both Worlds

Prior to 2008, Ken Carone, Managing Partner of Clearview Wealth Management LLC in Guilford, Connecticut, never set up a defined benefit plan for a client. During the last year, however, he set up three new cash balance plans and expects to set up five to six more in the coming year.

At one time, pundits predicted the demise of the defined benefit plans, but those plans, particularly cash balance plans, have made a comeback in the micro market. Cash balance plans provide opportunities for advisers to expand business. According to data from California-based advisory firm Kravitz, which designs and administers cash balance plans, 1,755 new cash balance plans were created from 2001 to 2006. Furthermore, most new cash balance plans are for firms that never had a defined benefit plan, says Scott Boulay, President, Boulay Donnelly & Supovitz Consulting Group in Worcester, Massachusetts. His firm is a full-service firm providing plan documentation, systems, and actuarial services for cash balance plans. The Pension Protection Act, which clarified the legality of cash balance plans, provides additional impetus for the design among start-ups.

The newfound popularity of defined benefit plans is primarily a micro-market phenomenon. According to Kravitz, 51% of new cash balance plans were for businesses with fewer than 25 active participants. Affirming that trend, the plans that Carone has set up are for firms with five to 30 employees. Clearview Wealth Management advises clients on assets of approximately $85 million, of which approximately 20% to 25% is in retirement plans. Right now, says Carone, less than $1 million of the assets the firm manages are in cash balance plans. However, he expects that will increase significantly in the next six to 12 months.

The appeal is obvious: The cash balance plan benefit structure addresses deficiencies in the traditional defined benefit plan model, says Boulay, and is relatively easier for employees to understand than traditional final average pay formula. Particularly attractive, he says, is the ability to get a lump sum on termination that can be rolled over, a feature not commonly offered in traditional final-average-pay defined benefit plans. Additionally, and probably most importantly, cash balance plans allow employers to contribute relatively large amounts to highly compensated employees, particularly owners and partners, on a tax preferential basis.

Specifically, by leveraging a defined contribution plan with a cash balance plan, says Boulay, substantial benefits can be provided to the firms’ key principals. Business owners are often willing to make increased staff contributions once it is explained how those contributions can be leveraged to create additional benefits for the highly compensated, says Daniel Kravitz, President of Kravitz in Encino, California. The Cash Balance Coach Program run by Kravitz teaches advisers to market and sell cash balance plans to their clients.

John Hancock Retirement Plan Services launched a new cash balance plan product targeted to professional firms and small businesses last year, notes Ed Eng, Senior Vice President for Product Development. The third-party administrator provides recordkeeping, plan design, and actuarial and compliance services. In addition to investment services, John Hancock provides benefit payment services, and participants can receive either recurring or lump-sum payments.

Plan Design

The cash balance savings program is especially beneficial when added to defined contribution programs. For example, increasing employer 401(k) and profit-sharing contributions 4% to 7% allows sponsors to create significant additional cash balance plan benefits for owners and executives, says Kravitz. A firm of any size may be able to realize upward of $250,000 contributions annually for an older employee in the combined defined contribution/defined benefit program, he says.

Boulay recently set up a plan for a firm with seven doctors and 30 employees. The doctors, ages 45 to 60, wanted to accelerate their retirement savings. The company’s defined contribution plan provides an employer contribution of 7.5% of compensation annually. By leveraging the profit-sharing allocation, the doctors are able to get $45,000 to $55,000 annually of cash balance benefit per doctor in addition to the 7.5% profit-sharing plan contribution.

Age Considerations

Age of key principals and staff is an important consideration in determining if a cash balance plan is right for a client. It is better if the key principals are older, because cash balance plan contribution formulas generally favor those closer to retirement by allowing for larger contributions. Advisers may find that Baby Boomer clients who have not saved enough for retirement will find cash balance plans particularly appealing, says Eng.

It is also beneficial if the non-principal staff is young. If the staff is older, it may become too costly to the owners to set up a cash balance plan because age is a factor in determining cash balance plan contributions. The older the staff, the larger the contributions that will have to be made on behalf of the staff, says Carone. Conversely, if the owners and executives are young, it may not make sense because the contributions to executives may not justify the costs of the program, says Kravitz.

For example, says Kravitz, suppose that a firm has four partners, ages 39, 39, 47, and 52, all of whom earn more than $225,000 annually. Under federal regulations, the two younger partners can receive a maximum 401(k) contribution of $15,500 and the older partners can receive $20,500 each annually. All four partners are entitled to a maximum profit-sharing contribution of $29,500. Under the cash balance plan, however, the 39-year-old partner can get $70,000, the 47-year-old partner $80,000, the 52-year-old $90,000, and the 62-year-old $185,000. Assume further that there are 34 other employees in which total contributions to the cash balance plan equal $107,200, says Kravitz. In this example, the total combined cash balance plan contributions to the partners more than offsets the contributions to staff. Conversely, if there were only two 39-year-old partners, the $140,000 total combined contributions to the cash balance plan for partners may be viewed as not worth offsetting the staff contributions and plan costs.

Advisers also should make sponsors aware that they are on the hook when plan investments do not meet goals, says Kravitz. Plan sponsors, says Boulay, are essentially promising a rate of return on account balances, and any shortfall has to be made up. Cash balance plans guarantee a rate of interest. The vast majority of cash balance plans peg the interest rate to rates of return on U.S. Treasury securities, says Boulay—for example, rate of return on a 30-year Treasury plus 0.5%. In recent years, he adds, this has resulted in crediting rates ranging from 4.5% to 6.5% annually. If investments do not hit that rate, the employer has to make up the shortfall. Because the sponsor is on the hook for investment losses, generally plan assets are invested to reduce volatility, says Boulay. Alternatively, when investments perform better than expected, it subsidizes future contributions or can be used to provide increased benefits, says Boulay.

Owners also have to be willing to support and fund the plan for at least five years, says Carone. Otherwise, he says, the Internal Revenue Service (IRS) may find that the plan was a tax avoidance scheme as opposed to true retirement planning. Thus, he says, a cash balance plan is not a good fit for a business planning to sell itself in a few years. It is also important that the business have stable earnings because contributions to fund benefits have to be made to the plan no matter what the firm’s profits are, says Carone.

Those requirements notwithstanding, there is significant flexibility in cash balance plan designs. For example, says Carone, if there is a medical group with six doctors but only four want to participate in the plan, it can be designed to accommodate those choices. However, he adds, it is important to work with a qualified consultant with actuary expertise available that can run the numbers so the plan does not run afoul of legal parameters.

Cash balance plans are a perfect opportunity for an adviser to show he can bring value to a client, says Eng. “Many small businesses are probably not aware that they can put away these large sums for retirement. It’s not well-known; because it’s not well-known, it’s a way for a plan adviser to show his value to the client,” he says.

Kravitz says that 401(k) plans have become a commodity, so cash balance plans are a great way for an adviser to add value because the plans are unique. Cash balance plans also can open the door to new 401(k) business. It is a great marketing tool, says Kravitz. More than 90% of the advisers who have completed Kravitz’s Cash Balance Coach Program typically win the 401(k) business along with the cash balance plan business, he says.

Laurence Balter, a principal with Wailea Capital Group in Maui, Hawaii, trained with Kravitz to sell cash balance plans in 2004. Since then, he has sold three to four plans a year and he always gets the 401(k) plan business with the cash balance plan business. He expects his cash balance plan sales to pick up this year. “If I were on the mainland,” he says, “I probably could sell two to three plans a month.”

Carone feels obligated to bring cash balance plans to clients. “It allows [the employer] to catch up significantly with retirement savings because of the sizable cash contributions that can be made,” he says. Carone also is actively marketing cash balance plans to other employers. “We see it as a great opportunity to expand our client base.”

Like Matters

Technically, a cash balance plan is a defined benefit plan. However, because these plans also have some of the characteristics of a defined contribution plan, they are frequently called “hybrids.’

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 plan assets and benefits promised in the plan document.
• The plans are insured 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:

• It establishes and credits individual accounts with income based on a predetermined formula/rate, regardless of the actual investment return of the plan.
• Balances accumulate gradually over an employee’s career.
• Traditional defined benefit plans tend to use a final-average-pay formula, while cash balance plans tend to use a career-average-pay formula. Without corrective action, this can hurt the retirement income of older workers who are close to retirement when their company makes the switch. —Nevin Adams

Illustration by Stefano Morri