Cash Balance Plans as Buy-Out Tools

September 1, 2010 – 5:11 pm

Cash balance plans can serve a multitude of purposes in partnerships and similar firms. We traditionally see them as retirement tools that allow shareholders to make very large tax-deductible retirement contributions while at the same time providing meaningful benefits to their employees. In this standard scenario, each individual partner is generally responsible for funding their own benefit.

However, a recent article highlights another way to harness the power of a cash balance plan: By using it as a tax-efficient way for older shareholders of a professional practice to sell their stake of the business to young owners. The article uses the example of a business owner (Founder) who wants $1M as payment for his share of the business. In a traditional sale situation, the remaining young partners (Youngsters) would have come up with $1M of after-tax dollars to be paid to the Founder, and the Founder would then have to pay capital gains taxes on the proceeds.

In an alternative scenario, a cash balance plan is set up such that the Founder’s projected benefit from the plan is $1M in his year of retirement. Then, in the remaining years between plan inception and the Founder’s retirement date, the Youngsters are responsible for contributing the money necessary to fund the Founder’s benefits. Because this is a qualified retirement plan, the contributions are tax-deductible for the Youngsters and the benefits are tax-deferred for the Founder.

The article goes on to provide some additional details, but I’d like to offer other points to consider:

  • The business transition approach may be a great idea for some firms, but it should be noted that in this situation the Founder does not get the benefit of lowering their taxable income through tax-deductible cash balance contributions. This is because the Youngsters are funding the Founder’s benefit.
  • The article mentions that each employee has their own individual account instead of “the vague promise of an ‘accrued benefit’ that may or may not be adequately funded”. I agree that each participant has a hypothetical account. However, this is a defined benefit plan so it can become underfunded since benefits are guaranteed but asset values can fluctuate depending on asset performance and contribution levels.
  • Some additional features that may be attractive to the Founder are the ERISA (and potentially PBGC) protections that come with a cash balance plan.
  • The number of years until the Founder’s intended retirement is a key consideration. There needs to be adequate time for the Founder’s benefit to accrue and for the Youngsters to make the necessary contributions.
By Mark Schulte | Posted in Cash balance plans, Defined benefit plans, Private pensions | Tagged , , | Comments (0)

Plan Termination Year vs. Short Plan Year

August 10, 2010 – 8:25 am

One confusing aspect of pension plan terminations is when the plan sponsor’s reporting obligation for the plan ends. Often there is the perception that a short plan year occurs during the year of plan termination, even if benefits are not distributed at that time. This post will clarify a few items with regard to short plan years and how they relate to terminating pension plans.

General Rule: In the case of a terminating pension plan, a short plan year does not occur until all assets have been distributed.

Example: Consider a calendar-year pension plan. If the plan is terminated on 6/30/2010 but assets are not fully distributed until 9/30/2011, then a short plan year does not occur until 2011. The 2010 plan year still ends on 12/31/2010 and the minimum funding requirements are still in effect for the 2010 plan year (see below).

5500 Implications: The due date for filing the annual IRS Form 5500 depends upon the end date of a short plan year. In a regular plan year, the Form 5500 would be due by the last day of the 7th calendar month after the plan year ends (or 9 ½ months with extension). The same methodology is true when there is a short plan year: the 7 and 9 ½ month due dates are based on the end of the short plan year, not on the regular plan year-end date. Care must be taken that Form 5500 due dates are not missed.

Example: Consider a calendar-year plan year beginning 1/1/2010. In a regular plan year, the latest filing deadline for the Form 5500 would be 10/15/2011. However, if the plan terminated in 2009 and paid out assets on 6/30/2010 then the latest filing deadline for the Form 5500 would be 4/15/2011 (i.e., 9 ½ months after the end of the short plan year).

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By Mark Schulte | Posted in Defined benefit plans, Private pensions | Tagged , , | Comments (0)

Retirement Deduction Limits and Employee Risk

August 6, 2010 – 8:57 am

A while back I read a blog post titled “The Beer Napkin Annuity” (BNA) that I found intriguing (if nothing else, the name is catchy). The basic premise was that perhaps we could adjust our retirement tax deduction rules to transfer some deduction opportunities traditionally reserved for defined benefit (DB) plans to defined contribution (DC) arrangements if the DC benefits had mandatory annuitization.

Background: There are two different annual deduction limits that apply when employers sponsor DB and/or DC retirement plans. Combined DC limits per participant are limited to $49,000 in 2010 (with catch up for older employees), while DB deductions can be much higher. If an employer does not offer a DB plan, then the DB deduction opportunities remain unused.

Thoughts: The BNA authors propose that some of the DB deduction limit be available to fund a DC benefit that must be annuitized so that participants cannot take the benefit as a lump sum. Instead they get a guaranteed stream of income, likely purchased through an insurance company (with balances invested by the participant) so that the plan sponsor relieves itself of some of the financial risk. The account balance at retirement would then be converted to an annuity stream of payments payable from the insurance company. The rationale is that these DC benefits with guaranteed income streams behave similar to DB benefits (which were traditionally paid as lifetime annuities) and thus could be deductible under the annual DB limits and not count towards the annual DC limits.

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By Mark Schulte | Posted in Defined benefit plans, Defined contribution plans, Private pensions | Tagged , | Comments (0)

GASB 45 Demographic Assumption Review

July 30, 2010 – 9:10 am

GASB 45 requires the measurement of public employers’ retiree health liabilities and many plan sponsors are now entering their second cycle of GASB 45 actuarial valuations.  These calculations are highly dependent upon the actuarial assumptions selected by the plan sponsor. Therefore, it’s a good idea to review these assumptions at each valuation cycle.

Many times, the assumptions used in the first GASB 45 valuation are rough estimates of a plan’s expectations for certain demographic events such as future retirees’ expected retirement age and the likelihood that a retiree will elect to enroll in the employer’s health plan. Once the initial GASB 45 actuarial valuation is complete, however, public employers should start monitoring their plan’s experience to ensure that their assumptions are consistent with what is actually happening. This post discusses some of the important demographic assumptions that should be monitored.

1. Retiree participation rates. This is the likelihood that a retiree will actually enroll in the employer’s health plan. If the plan only provides coverage and the retiree pays the entire premium, then it is likely that the participation rate is less than 100%. Plan sponsors should monitor their retirees each year and note how many actually elect coverage. This assumption is particularly powerful: if you decrease your participation assumption by 50% then your liabilities (at least for active employees) will decrease by 50% also. Read More »

By Mark Schulte | Posted in GASB 45, Other post-employment benefits (OPEB) | Tagged , , | Comments (0)

Rejection of 2009 Form 5500 Filing Relief

July 26, 2010 – 9:56 pm

It was a bit of a longshot to begin with, but the American Benefits Council’s proposal for a blanket extension for filing of 2009 Forms 5500 until December 31, 2010 (or 9 1/2 months after the end of the plan year, if later) was recently rejected by the DOL. As the DOL mentions in their response letter, the current Form 5558 extension is not a difficult filing and should allow ample time for plan sponsors to file their Forms 5500.

The main reason for the ABC’s request was the new requirement that pretty much all 5500 filings be completed electronically (starting with the 2009 plan year filings due this year). The EFAST2 filing system is finally up and running, but initial experience has been less than stellar. We have had first-hand experience with some of the technical difficulties that vendors are experiencing in dealing with supposedly EFAST2-compliant software that still has some bugs to be ironed out. That being said, it is probably not worth trying to force the completion of a 5500 filing by the end of July since in most cases it is quite simple to just file the 5558 extension. Hopefully in the next few weeks the EFAST2 system will be running smoother and third-party software will have overcome most of its growing pains.

By Mark Schulte | Posted in Defined benefit plans, Defined contribution plans, Private pensions | Tagged , | Comments (0)

Cash Balance Gateway Contributions

July 15, 2010 – 9:45 am

One of the hurdles that business owners face when exploring a cash balance plan is deciding whether the cost of the plan justifies the cash balance deduction opportunities. It is a bit of a balancing act, but this post will review one such cost: the IRS “gateway contribution” for cross-tested cash balance plans.

The IRS allows cash balance plans to have some acceptable disparity between benefits provided to owners versus those provided to non-highly compensated employees. Most small-firm cash balance plans utilize these rules through a process call “cross-testing”. The cross-testing mechanisms are VERY complex and we won’t delve into the intricacies here, but the basic theory is:

  1. Large benefits are provided to owners through the cash balance plan.
  2. A reasonable benefit is provided to non-highly compensated employees through an annual profit sharing plan allocation.
  3. In order for the cash balance plan to pass the IRS non-discrimination testing rules, the cash balance benefits are combined with the profit sharing benefits and a single IRS nondiscrimination test is performed.
  4. IRS rules mandate that if a cash balance plan is cross-tested, then the total annual allocation for each non-highly compensated employee must be at least 7.50% of pay. This 7.5% minimum benefit is the “gateway contribution”.

So, many potential plan sponsors will learn during the plan design process that they have to provide their employees with retirement benefits equal to 7.50% of pay each year. If you are already giving employees a 5% profit sharing contribution each year, then it may be palatable to give them another 2.5% either in the profit sharing plan or in the cash balance plan. This could allow each of the owners to have an annual cash balance accrual of $100,000 or more.

However, if you have a large employee base (relative to the number of owners) or do not already provide generous retirement benefits to your employees, then you may find the cash balance gateway requirement of 7.5%-of-pay to be cost-prohibitive. This is one of the warning flags we talked about in our previous Eyes Wide Open post. For more information on the nuts and bolts of cash balance plans, please feel free to visit our cash balance plan informational website: www.safecashbalance.com.

By Mark Schulte | Posted in Cash balance plans, Defined benefit plans, Private pensions | Tagged , , , | Comments (0)

Pension funding relief bill signed today

June 25, 2010 – 10:38 am

This just in:  President Obama signed the Preservation of Access to Care for Medicare Beneficiaries and Pension Relief Act today.   Title I of the Act is about Medicare physician reimbursements, and Title II is about pension funding relief.

The funding relief is in the form of extended shortfall amortization periods.  Employers who choose to can take more than the usual seven years to pay off a funding deficit.

There’s a catch, though.  Several catches, actually.  If you take the relief, you have to notify the PBGC and all your plan participants.   And you have to make extra pension plan contributions if you pay any employee more than $1 million, pay extraordinary dividends or buy back an unusual amount of company stock.

By Jim van Iwaarden | Posted in Defined benefit plans, Private pensions | Comments (0)

Cash Balance Plans: Eyes Wide Open

June 25, 2010 – 8:32 am

As we’ve mentioned in previous posts, there has been a lot of press this year about cash balance plans and how they can provide great retirement deferral opportunities for certain types of plan sponsors: law firms, physicians groups, and small employers. However, there is the occasional case of buyer’s remorse with these plans so I thought that I’d point out some indicators of when someone may not be a good candidate for a cash balance plan.

1. Unpredictable cash flow: Cash balance pension plans generally require annual contribution that are mandated by the IRS. If your business doesn’t have a predictable cash flow, then a profit sharing plan might be a better option (though it has lower deduction limits).

2. You haven’t maximized your 401(k)/profit sharing deferrals yet: Business owners looking for retirement savings deductions should start with a 401(k) or profit sharing plan. These plans provide the opportunity for combined deductions of around $49,000 per owner per year (plus catch-up contributions). If you are already deferring the maximum amount into these plans and want to defer significantly more, then a cash balance plan might be a good fit.

3. You don’t want to give additional benefits to your employees: Sponsoring a cash balance plan that has high deductions for owners generally requires that employees receive a total allocation (401(k) plus profit sharing plus cash balance pay credit) of 7.5% of pay per year. If you are already giving employees a retirement allocation of 6.0% of pay per year, then the additional 1.5% may not be a big deal. Otherwise, you’ll want to make sure that your personal deductions will be large enough to justify the added benefits expense.

4. You want to take your money out of the plan right away: The IRS requires that cash balance plans have “permanence”, and one rule of thumb is that this means they must be around for at least 5 years before they are terminated and assets rolled over.

5. You don’t want to pay any fees to maintain a plan: As with any qualified retirement plan (pension or 401(k) plan) there are certain fees associated with sponsoring a cash balance pension plan. There are start-up costs to design and implement the plan, maintenance costs each year, and tail-end costs when the plan is terminated. These expenses are relatively fixed each year, so you want to make sure that you are maximizing your deferral opportunities in order to justify the expenses.

The items above aren’t meant to scare you away from cash balance plans, but rather are meant to address some common criticisms. For many businesses, a properly designed cash balance plan can provide huge tax deduction opportunities and be an integral part of owners’ retirement planning. To see if a cash balance plan would make sense for you, it’s a good idea to consult with your financial planner and also to get a good plan design analysis from an actuary.

By Mark Schulte | Posted in Cash balance plans, Defined benefit plans, Private pensions | Tagged , , | Comments (1)

Pension Liability Primer

June 17, 2010 – 10:13 am

Here’s a link to a presentation I gave to an accounting firm and some of their clients yesterday. It is geared towards plan sponsors and gives a high-level overview of the basis for calculating pension liabilities. The presentation also reviews and compares various pension liability results so that plan sponsors can better understand what all the numbers mean.

By Mark Schulte | Posted in Defined benefit plans, Private pensions | Tagged , , | Comments (0)

PBGC APFT Relief

June 10, 2010 – 7:13 am

In an earlier post, we highlighted how the PBGC was rejecting a number of 2009 pension insurance premium filings because plan sponsors had completed the forms incorrectly. New rules effective in 2009 allow plan sponsors to make an election to use an Alternative Premium Funding Target (APFT) instead of the Standard Method. Many plan sponsors intended to make the APFT election, but they didn’t correctly fill out the PBGC form which documents this choice.

After much pressure from plan sponsors, industry organizations, and congressmen, the PBGC finally relented on Tuesday and released a statement saying that they would be providing limited relief to plan sponsors who:

  1. Filed their PBGC premium forms on time;
  2. Used the APFT to determine their Variable Rate Premium (VRP); and
  3. Checked the box on Line 7(d)(1) indicating that the APFT was used.

If a plan sponsor satisfies these conditions but forgot to check Box 5, then they get relief from the PBGC and won’t have to pay the Standard Method VRP or pay late interest penalties. No other documentation will be required, but relief must be requested within 30 days.

By Mark Schulte | Posted in Defined benefit plans, Private pensions | Tagged , , | Comments (0)