The Pension Protection Act of
2006 (PPA) changed many of the rules affecting defined benefit and cash
balance plans. Recent regulations have helped to make such plans more
stable, and consequently more attractive to plan sponsors. New design
opportunities now exist for these plans, individually and in combination
with defined contribution plans. What follows is an overview of the new
provisions along with some plan design illustrations.
Types of Retirement Plans
There are two basic types of qualified retirement plans: defined benefit
and defined contribution. A defined benefit (DB) plan promises a specified
benefit at retirement for each participant, usually in the form of a monthly
annuity payable for the life of the participant (or the joint lives of the
participant and a designated beneficiary). This benefit is often based on a
participant’s compensation and/or years of service. An actuary determines
the amount that must be contributed each year in order to ensure that the
funds are available at retirement age. DB plans are often funded entirely by
employers, who bear the risk for investment gains or losses.
Most DB plans are subject to insurance premiums of the Pension Benefit
Guaranty Corporation (PBGC), a government agency that insures plan benefits.
Plans that only cover owners or are sponsored by professional service
companies with fewer than 25 employees are exempt from PBGC coverage.
In a defined contribution (DC) plan, benefits are provided from account
balances that are funded by employer contributions, employee contributions
(such as salary deferrals) or a combination of the two. These contributions
along with actual investment earnings comprise the benefits at retirement.
Cash Balance Plan
A cash balance plan is a hybrid—a DB plan that in some ways resembles a
DC plan. Each participant receives an annual contribution credit (usually a
percentage of pay) and an interest credit based on a guaranteed rate that
may change from year to year. The participant’s "account balance" is the sum
of all contribution and interest credits. These plans are also subject to
PBGC coverage with the exceptions noted above.
As in a traditional DB plan, the employer in a cash balance plan bears
the investment risk. An actuary determines the contribution to be made to
the plan, which is the sum of the contribution credits for all participants
plus the amortization of the difference between the guaranteed interest
credits and the actual investment earnings (or losses). Participants
appreciate this design because they can see their "accounts" grow but are
still protected against fluctuations in the market.
In order to determine contribution and benefit limitations, the actuary
converts the guaranteed interest and contribution credits to a monthly
benefit at retirement age. Such benefit may not exceed 100% of pay or a
specified dollar amount which is adjusted for inflation ($15,000/month as of
2007 for retirement age 62 or later). Contributions in a cash balance plan
can be significantly higher for an older employee than the DC contribution
limit ($50,000 as of 2007, including catch-up contributions).
Testing for Nondiscrimination
All plans must meet certain stringent guidelines or pass
nondiscrimination tests. These rules are designed to ensure that plan
benefits or contributions do not discriminate in favor of "highly
compensated employees" (HCEs), generally defined as those who own more than
5% of the employer or earned more than a specified amount in the prior year
($100,000 in 2007). All others are considered "non-highly compensated
employees" (NHCEs).
When performing nondiscrimination testing, either the benefit at
retirement or the annual contribution is compared between HCEs and NHCEs.
The type of testing selected need not coincide with the type of plan that is
adopted. That is, a DB plan can be tested on a contribution basis and a DC
plan can be tested on a projected benefits basis. Testing in this manner is
referred to as "cross-testing."
DB Problems Prior to PPA
DB plans have fallen out of favor over the past several years.
Legislative changes forced these plans to value lump sum payouts to
terminated participants as much as two to three times higher than the amount
accumulated for them under the plan, which led to funding deficiencies.
Also, deduction limits did not allow employers to make extra contributions
while the economy was strong. When the economy weakened, market losses
increased underfunding and many sponsors were faced with rising costs at a
time when corporate profits were lower than usual.
Cash balance plans were also affected by the lump sum payout rules. Once
again, participants would receive far in excess of their "account balance,"
and the plan sponsor would have to amortize the difference. In addition,
cash balance plans were plagued with legal problems as some courts found
conversions from traditional DB plans to be age discriminatory.
DB Plans After PPA
Under PPA, the funding and lump sum payout rules are being brought into
balance. Plan sponsors now have the option of making additional deductible
contributions to fully fund the plan and even pre-fund future accruals. In
addition, over a period of four years, new rules for lump sum payments will
be phased in, resulting in lump sum distributions that are closer to the
amount of benefits funded.
Cash balance plans are also provided relief, as long as they follow
certain rules regarding interest rates. Lump sum distributions to
participants will now equal their "account balances," without adjustment for
various other published interest rates. In addition, PPA clarifies that cash
balance plans that follow the new rules are not age discriminatory.
These changes significantly improve the outlook for DB plans by making
them more practical and predictable in both costs and benefits. Employers
can now take advantage of the unique design alternatives available to these
plans. Following are some illustrations.
Cash Balance Plan Example
A cash balance plan can provide partners of different ages the same
benefit, as illustrated below. The plan formula is 38.636% of pay for owners
and 16% of pay for non-owners.
| Employee |
Age |
Compensation |
Contribution |
| Partner A |
51 |
$220,000 |
$85,000 |
| Partner B |
58 |
$220,000 |
$85,000 |
| NHCE |
31 |
$25,000 |
$4,000 |
The contribution and interest credits are projected to normal retirement
age for each participant and then converted into a monthly accrued benefit.
The accrued benefits are compared for nondiscrimination testing. As a
percentage of pay, the NHCE’s benefit at retirement is greater than that of
the two partners (who are HCEs), so the plan is not discriminatory.
Combined Plan Designs
In the past, an employer’s maximum deduction to all plans for a fiscal
year equaled the greater of the required contribution for the DB plan or 25%
of total participants’ eligible compensation. Under the new rules, as of
2006 an employer can contribute up to 6% of pay to a DC plan in addition to
the required DB contribution, even if the resulting total exceeds the 25%
limit. Employee deferrals do not count towards the 6% or the 25% limit. This
new rule offers many opportunities for a combined plan approach.
DB + Safe Harbor 401(k) Combo
Shown below is a DB plan for 2006 in which the contribution exceeds
25% of payroll. Under the new rules, the employer can also adopt a safe
harbor 401(k) plan that meets the 401(k) nondiscrimination requirements by
guaranteeing a 3% of pay contribution to all NHCE participants. The plan
also allows discretionary profit sharing contributions. In this example the
profit sharing contribution is allocated on a cross-tested basis, with a
higher percentage going to the owner, who is older. The sum of the safe
harbor and profit sharing contributions cannot exceed 6% of total
participant compensation.
| Employee |
Age |
Salary |
DB Cost |
Deferral |
PS Contrib.* |
| Owner |
52 |
$220,000 |
$133,518 |
$20,000 |
$14,250 |
| Assistant |
25 |
$35,000 |
$5,334 |
unknown |
$1,050 |
| Total |
|
$255,000 |
$138,852 |
$20,000+ |
$15,300 |
| *Profit sharing contribution includes the
3% safe harbor contribution. |
Prior to 2006, this sponsor would have only been able to deduct the DB
contribution, and the owner’s salary deferrals would have been limited based
on what the assistant deferred. The addition of the safe harbor 401(k)
profit sharing plan allows the owner to increase his own contribution by
$34,250 with an additional contribution for the assistant of only $1,050.
The assistant can further benefit by making pre-tax salary deferrals into
the 401(k) plan.
Cash Balance + Safe Harbor 401(k) Combo
Here is an illustration of a cash balance plan with a safe harbor 401(k)
profit sharing plan for 2006:
|
Employee |
Age |
Salary |
Cash Balance Cost |
Deferral |
PS Contrib. |
|
Owner 1 |
59 |
$220,000 |
$100,000 |
$20,000 |
$14,283 |
|
Owner 2 |
54 |
$220,000 |
$100,000 |
$20,000 |
$14,283 |
|
Other HCE |
56 |
$120,000 |
$3,000 |
$6,600 |
$6,672 |
|
8 NHCEs |
various |
$372,470 |
$9,312 |
unknown |
$20,710 |
|
Total |
|
$932,470 |
$212,312 |
$46,600+ |
$55,948 |
Over 85% of the employer contribution is allocable to the owners and they
can each defer $20,000 as well. The profit sharing contribution is allocated
on a cross-tested basis, with different percentages going to the owners, the
non-owner HCE and the NHCEs.
The plan design can go even further by excluding some employees from each
plan and combining the plans for testing purposes. It can be useful if you
have both older and younger HCEs. The younger HCEs can benefit under the DC
plan while the older HCEs benefit under the DB plan.
Note that effective in 2008, DB plans covered by the PBGC will no longer
count towards the 25% contribution deduction limit. As a result, sponsors of
PBGC insured plans will be able to fund a DC plan up to 25% of compensation
in addition to their DB plan.
Other DB Plan Considerations
Employers interested in adopting a DB plan should be willing to commit to
the contribution requirements of these plans over the long run. There is
little flexibility in calculating required contributions. The plans also
tend to be more expensive to administer and, if covered by the PBGC, will
incur premium expenses. However, these costs may be far outweighed by the
ability to fund significant amounts towards retirement.
The value to a particular employer of any of the plan designs outlined
previously is highly dependent upon the ages of the participants. Each of
these designs is subject to complicated nondiscrimination requirements which
must be performed annually. Changes in the employee census can cause
significant changes in the costs and allocations.
Conclusion
PPA has created new plan design opportunities that incorporate DB plans.
Traditional DB plans are now less likely to become underfunded with
distributions mirroring accumulated contributions with interest. A cash
balance plan is a viable alternative to the traditional DB plan, offering a
benefit more easily understood by participants. Cash balance plans also
allow employers to equalize contributions for key employees of different
ages.
Combining traditional DB or cash balance plans with DC plans can greatly
expand contribution possibilities. These designs can be highly
individualized to best match the census of the plan sponsor. Employers who
are interested in increasing their annual contributions and are willing to
commit to these contribution levels should seriously consider the
alternatives that now exist.
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