Plans Designed For Small Business Owners
Employers often adopt defined benefit plans so they can provide full retirement benefits to employees who are older at plan commencement. Since defined benefit plans provide specified benefits, rather than just whatever benefit can be accumulated by the participant’s account balance at retirement, defined benefit plans are well suited to situations in which the employer establishes the plan late in an employee’s career and wants to provide a significant retirement benefit.A cash balance plan is often selected in situations where the employer wishes to provide benefits based on compensation rather than a combination of age and compensation. In a cash balance plan, employees with the same compensation receive the same pay credit regardless of age. This is particularly useful in the situation where the plan sponsor wishes to provide the same benefit to partners who are different ages.
In general, a defined benefit plan or cash balance is most effective if the favored employee is age 45 or older. This is because the compression of the funding of the favored employee’s benefit into the 10-15 year period immediately prior to his retirement produces the largest contributions. For a younger participant, funding may also be compressed into a 10-15 year period, but the contributions will be less because the participant is many years from retirement. This may be an appropriate and tax effective design if a young principal expects his highest earnings years will be the 10-15 year period after the cash balance plan is established or if he wishes to make the bulk of his contributions to the cash balance plan in these years.
For plans of professional service employers or small businesses with no rank and file employees, this will require giving up the opportunity to make current contributions in excess of 6% of compensation to the defined contribution plan, an opportunity which cannot be recaptured, in order to make contributions to the defined benefit plan or cash balance plan.
If the employer chooses to wait until a future year to establish a defined benefit or cash balance plan, contributions will be larger as the principal will be older and thus the foregone contributions in earlier years can be recaptured.
In a cash balance plan, each participant has a hypothetical account, called a cash balance account, which is credited with annual pay credits and interest credits. Pay credits can be a percentage of compensation, a flat dollar amount or other amount defined in the plan. Pay credits can be different for various groups (similar to a cross-tested or new comparability plan). Interest credits must also be defined in the plan. The interest crediting rate may be a flat rate or may be determined by reference to an index or published rates (such as the 30 year Treasury rates). The Pension Protection Act allows the use of a “market related rate”, but additional guidance is required to determine how such rate is to be computed and how it will impact plan funding and non-discrimination testing. With regard to its funding, a cash balance plan works the same as a defined benefit plan except that the defined benefit at retirement is the projected amount in the participant’s cash balance account at retirement rather than a monthly benefit. The contribution is the variable and is determined by the plan’s actuary each year. Each year, the actuary will provide a range of contributions to the defined plan including the minimum required contribution, a recommended contribution and the maximum deductible contribution. The recommended contribution is the amount that should be contributed in order to properly fund the plan such that all benefits can be paid when due. The minimum contribution will satisfy IRS requirements, but will likely result in the need for increased contributions in future years. The maximum deductible contribution includes the maximum allowable advance funding and will likely result in lower contributions in some future years. The amount of the contribution depends on the level of benefits, the ages and compensations of the participants and expectations regarding investment earnings, salary increases, turnover and other factors. Generally, the sum of the contribution credits will be within the range of contributions provided by the actuary. While the contribution attributable to funding a participant’s benefit is not exactly equal to his contribution credit, it is generally close enough for plan sponsors to be comfortable in using it to understand the cost of the plan. In a cash balance plan, annual contributions are required — not discretionary. While it may look like a profit sharing plan, it is a defined benefit plan and subject to the funding requirements applicable to defined benefit plans. Contributions are determined for the plan as a whole, not as individual amounts for each participant.
Assets are not individually directed, but are held in a pooled account. Contributions are paid into the pool and benefits are paid from the pool. The plan sponsor and/or trustee is responsible for managing the plan’s assets and usually works with a broker or financial institution to manage the investments. In a cash balance plan, accounts are hypothetical and do not reflect the actual return on plan assets. Plan assets are managed as described above — individual accounts are not established and participant direction is not permitted.
The maximum benefit contribution limit for a participant in a defined benefit plan is defined in terms of the maximum benefit that can be provided at retirement, not in terms of a maximum contribution. Contributions are not limited to the lesser of 100% of pay or $53,000 as they are in a defined contribution plan. Instead, the maximum benefit that can be provided is limited to a benefit equal to the lesser of 100% of a 3 year high average compensation or $265,000 (as indexed, with various adjustments for short service/particiapation and retirement prior to age 62).