Hybrid Pension Plans ~ Defined Benefit & Defined Contribution All In One:
With rising gas prices, automobile manufacturers are designing and
building more and more hybrid cars. Hybrid’s are popular due to their
tremendous fuel efficiency. In the same way the goal for small businesses
is to acquire efficiently designed and run. often, Hybrid
Retirement Plans.
LeagueFinancial has consistently developed plan designs that favor the
small business owner’s goals of large deductible contributions (e.g.
412(i) and Defined Benefit Pension Plans) and/or we have provided the
owner(s) with the largest share of the plan contribution (New
Comparability, Profit Saring and Safe Harbor 401(k) Plans).
We are now
recommending the Hybrid "Cash Balance Pension Plan", in
many situations, made feasible for a small business by the Pension
Protection Act of 2006. The PPA describes it as a "Hybrid" plan. Cash
balance earns this description because it has both defined benefit
and defined contribution features.
Defined benefit
characteristics include:
- Benefits must be definitely determinable and stated in the
plan document
-
Contributions are required annually at the stated level
- The plan
sponsor assumes the investment risk (no participant direction)
- Defined
benefit 415 limits apply (i.e. no $45,000 limit)
Defined Contribution
characteristics include:
- The participant’s have an account balance
-
Contributions and interest are added to the account annually
-
Contributions can be skewed by class to favor owner and key employees
Features Further Explained:
The contribution and interest credited to participant’s accounts must be
guaranteed by the plan; hence participants do not get to direct
investments in their accounts. If the plan’s investments earn less than
the promised rate the employer must make up the difference.
Conversely, if the plan earns greater than the guaranteed rate, the excess
amount would reduce the employer’s required contribution. This is exact
opposite of what we are accustomed to with defined contribution plans,
where the actual rate of return (or loss) is exactly what is credited to
the participant’s accounts.
Defined Benefit Plans Contrasted:
Defined Benefit Plans, since the PPA, now have contribution flexibility,
with a minimum and maximum contribution being named annually, where any
contribution in between will meet IRS funding rules. And include the
following:
-
plans have more investment flexibility since they
can invest in a group variable as well as a fixed annuity
-
plans can be funded exactly like a 412(i) if they
want absolute guarantees
-
can sometimes get as high or higher contribution in
the first year (e.g. one can’t create any higher cash distribution in
a 412(i) than in a traditional Defined Benefit Plan)
-
can now fund with insurance in the same manner for
those wanting the guarantees vs. the potential risks inherent in
equity investing.
A CASH BALANCE PLAN WILL
BALANCE THE PLAN’S CASH:
One of the age-old problems in dealing with small
business partners is equalizing the cash contribution to a defined benefit
pension plan when the owners have a wide age discrepancy. Note the
Traditional Defined Benefit Plan allocation among the two owners and three
employees in the example below. Since the "older" doctor receives 4 TIMES
the contribution of the "younger" doctor, the plan is unlikely to ever be
adopted:
|
PARTICIPANT |
AGE |
TRADITIONAL DEFINED BENEFIT PLAN CONTRIBUTION |
| "OLD DOCTOR" |
62 |
$190,000 |
| "YOUNG DOCTOR" |
43 |
$48,000 |
| 3 EMPLOYEES |
|
$7,528 |
|
TOTAL
CONTRIBUTION |
$245,528 |
Enter the Pension Protection Act.
Enter the green light for the Hybrid-Cash Balance Defined Benefit Plans,
and note the difference in the above example when using a plan design Cash
Balance & 401(k) Combined as shown below:
|
PARTICIPANT |
AGE |
CASH BALANCE & 401(k) PLAN CONTRIBUTION |
|
"OLD
DOCTOR" |
62 |
$100,000 |
|
"YOUNG
DOCTOR" |
43 |
$100,000 |
|
3
EMPLOYEES |
|
$5,810 |
|
TOTAL
CONTRIBUTION |
$205,810 |
Even with a wide age
discrepancy, the two doctors now receive exactly the same dollar
allowcation and 97% of the total contribution, and the total overall
contribution required is reduced.
The Exciting Features of a Hybrid-Cash Balance Plan Include:
-
the plan can use
the defined benefit contribution limit for the owner rather than the
$45,000 defined contribution limit
-
contributions can
be skewed in favor of the owner by creating classes of employees
as we have become familiar with in new comparability plans. This
allows us to create an "efficient" plan design by providing the
maximum contribution for the owner while making lower contributions
for the other employees. From a contribution standpoint, then, a cash
balance plan can be looked at as a new comparability plan without the
$45,000 contribution limit for the owner class.
-
the business is allowed to
make the exact same contribution amount for all of the members of
the "owner" class of employees. This means if we have different
age owners they can still receive the same contribution amount. That
often is not possible in most other plan designs but is most often
what business owners need and want.
The following Chart 1 shows
the benefit to the owner of a cash balance plan design over a new
comparability plan for a small business with 4 employees.
| CHART 1: |
|
|
|
|
|
| |
|
Age |
Salary |
New Comparability |
Cash Balance |
| Owner |
|
55 |
225000 |
45,000 |
153,000 |
| EE 1 |
|
44 |
34,000 |
1,700 |
5,380 |
| EE 2 |
|
36 |
30,000 |
1,500 |
4,750 |
| EE 3 |
|
25 |
28,000 |
1,400 |
4,430 |
| EE 4 |
|
22 |
20,000 |
1,000 |
3,160 |
|
Totals: |
|
|
337,000 |
50,600 |
170,720 |
| |
|
|
Owners Share: |
89% |
90% |
The higher contribution
allowed requires a slightly higher contribution for the employees, but
note that the owner’s percentage share actually increases in this
particular situation.
The next Chart
2 illustrates the benefit of a Hybrid Cash Balance Plan design for a
business with two different aged owners:
| CHART 2: |
|
|
|
|
|
| |
|
Age |
Salary |
Allocation |
% of Salary |
| Owner 1 |
|
61 |
225,000 |
150,000 |
67% |
| Owner 2 |
|
54 |
225,000 |
150,000 |
67% |
| EE 1 |
|
48 |
34,000 |
6,075 |
18% |
| EE 2 |
|
35 |
30,000 |
5,360 |
18% |
| EE 3 |
|
32 |
28,000 |
5,005 |
18% |
| EE 4 |
|
26 |
20,000 |
3,575 |
18% |
|
Totals: |
|
|
580,000 |
320,015 |
|
| |
|
|
|
Owners Share: |
94% |
A higher contribution amount
is required for the employees than we’ve seen in the past with new
comparability, but the two owners are both getting an equal
contribution substantially larger than the $45,000 defined contribution
limit and they receive 94% of the total plan contribution. The
cost of benefits for the employees is more than paid for by the tax
savings the business receives for this substantially higher contribution.
Another significant benefit
that comes with Cash Balance Plans is that they are suitable for larger
employers then we typically see with defined benefit or new comparability
plans.
A recent 25 life medical practice allowed a design that would provide a
$103,000 for each of the 5 physician owners while requiring only a $60,373
contribution for the 20 other employees, meaning that $515,000 of a total
$575,373 contribution, or 90% was targeted for the owners of the
practice.
Cash Balance Plans cannot
utilize "prototype documents", so each plan has to be submitted to the IRS
for a Letter of Determination. Generally this will add an IRS user fee
of $1,000 in addition to normal plan installation fees, but in the
overwhelming number of cases is well worth the overall improvements
offered via Hybrid plans such as this.
Hybrid plans, like the Cash
Balance Plan, is not the panacea for all situations. However, plans that
create higher contributions for business owners, lower contributions for
non-key employees and the bring about the ability for businesses to be
able to equalize the contributions for multiple owners, can only help.
