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THE PENSION STUDIO PLANS
The Pension Studio can assist you in designing the plan that best fits your company's needs. Please refer to the news page for up-to-date plan limits and information.
Defined Benefit Plans provide a fixed, pre-established benefit for employees. Some employers find that defined benefit plans offer business advantages. For instance, employees often value the fixed benefit provided by this type of Plan. In additional, employers seeking higher annual contributions (and tax deductions) find these plans to be the best option.
Cash Balance Cash balance plans are considered defined benefit plans, which are traditional pension programs that promise workers a specific monthly benefit at retirement. But cash balance plans actually behave more like defined contribution plans (401(k) plans, for example).
Cash balance plans commonly are designed to provide a certain percentage of salary for each year's benefit accrual (for example, 2% of annual compensation). And the balance in the employee's account grows each year with interest usually tied to a conservative index such as short-term Treasury rates. The interest rate is guaranteed under the terms of the plan document, and the employer must make up any shortfalls if the investment return is less than this rate.
Though a cash balance plan has the advantage of being portable, trustees still manage the assets. The assets aren't separated into personal accounts for each employee, but the individual accounts are maintained through the use of an administrative record-keeping system.
Because cash balance plans are defined benefit plans, benefit levels are guaranteed and annual actuarial valuations are required. The valuation determines the employer's annual contribution to the plan and the plan's funding status. Annual premiums are payable to the Pension Benefit Guaranty Corp.
Cash balance plans are viewed as "hybrid" retirement plans because they possess some characteristics of defined contribution plans even though they're defined benefit plans. They're actually career average plans because benefits accumulate based on accruals tied to a participant's annual compensation rate over the participant's working career.
Traditional defined benefit plans usually base the benefit on a three or five-year average of compensation over the participant's final years of employment, when compensation is the highest.
Profit Sharing Plans Profit Sharing Plans contain employer contributions only. These contributions are discretionary. Depending on the plan terms, there is often no set amount that an employer needs to contribute each year. Contributions that are made are allocated among eligible employees based on a formula stated in the plan terms. The funds then go into separate accounts for each employee. As with 401(k) plans, profit-sharing plans can vary greatly in their complexity.
Cross Tested: Employer contributions are allocated based on groups. Vesting and eligibility are flexible. Very beneficial to owners and key employees if demographics are right.
Integrated: Employer contributions are allocated based on a formula that benefits those earning above the TWB. Vesting and eligibility requirements are flexible.
401(k) Plans 401(k) Plans have become widely accepted saving vehicles for small businesses. Today an estimated 42 million American workers are enrolled in 401(k) plans that have assets of $2 trillion. With a 401(k) plan, employees can elect to defer a portion of their income into an account that goes into their name (up to $16,500 for 2010 - $22,000 for employees age 50 or over). The employer has the option to contribute to these accounts either through a matching contribution or a flat percent of pay contribution. Generally the deferrals (plus earnings) are not taxed by the Federal government or by most local and state governments until distributed. The employer deducts contributions made to the plan.
401(k) Plans are available for businesses with only the owner as an employee. We call these Solo Plans and can offer them through Charles Schwab. We also offer traditional 401(k) plans through Charles Schwab and may other custodians such as John Hancock.
DB/DC Combination Plans Combining a 401(k) Plan & a DB Plan
The Pension Protection Act of 2006 included provisions that enable a successful small business to combine a 401(k) with a Defined Benefit Plan. This Defined Benefit Plan can be either Traditional, or a Cash Balance Plan.
A couple of key items to keep in mind when combining a 401(k) Plan and a DB Plan are:
• An owner’s salary deferrals under a 401(k) Plan do not affect the DB Plan’s deduction limit. This could effectively increase the amount the owner could contribute by $16,500 (or $22,000 if age 50 or older) in a properly designed plan.
• Company contributions of up to 6% of covered compensation may be made to a DC Plan without affecting the DB Plan’s deduction limit. This PPA ’06 change makes it possible to add a Safe Harbor 401(k) Plan to a traditional DB Plan, even for small employers.
There are a number of factors to consider in contemplating a DB/DC Combination Plan for your business or client. Being aware of all of the components and their advantages and limitations is vital in Plan Design decision-making.
Defined Benefit Pension Plan
The contributions for Defined Benefit Plans are calculated based on the employees' age and compensation. The older the employee and the more compensation (up to IRS compensation limits), the larger the contribution required for the employee. These plans are not subject to the 25% employer deduction or participant contribution limitations and can provide a substantially higher benefit than can be provided with a traditional Defined Contribution Plan.
DB Pension Plans work especially well with owners or key employees more advanced in age than the other employees. DB Plans can even be set up for single employee businesses. The plan can be used with any number of owners, key employees and other employees. However, it is important to keep in mind that the Defined Benefit Plan should be considered a commitment to retirement. This is not to be considered as a “flexible” plan, but an annual required commitment.
DB Plan combined with a 401(k) Plan or a Safe Harbor 401(k) Plan
In order to be able to contribute more towards retirement, an Employer may choose to add a 401(k) Plan or a Safe Harbor 401(k) Plan to a DB Plan, or vice versa, increasing the owners ability to save by at least $16,500 (or $22,000 if age 50 or older) on an individual Pre-tax or Roth (After-tax) basis. Though the DB Pension portion of the Combination Plan is required, the 401(k) Plan is more flexible with discretionary options that can be utilized one year, but perhaps not the next.
With this combined-plan design, the employer contribution to the 401(k) Plan must be no more than 6% of covered compensation. Then the employee deferral 401(k) contributions, whether they are Pre-tax or Roth, do not impact the contributions to the DB Plan. The next step may be to include a Discretionary Profit Sharing Feature allocation using the New Comparability method.
DB Plan combined with a 401(k) with a New Comparability Allocated Profit Sharing Plan
Since the contributions for New Comparability Profit Sharing Plans are based on the employees' age, compensation, employee classes and the percent of contribution decided by the employer, this is a sound addition to any 401(k) or Safe Harbor Plan combined with a DB Pension Plan.
New Comparability Profit Sharing allocation formulas work extremely well where the owners or key employees are more advanced in age than other employees. Using this feature in conjunction with a 401(k) plan provides even more opportunity for the Owners and/or Key Employees to receive a larger share of the total Employer Contribution to the Plan combination. Another advantage is that this feature is clearly discretionary and can be utilized on a year-to-year basis.
Cash Balance Plan combined with a 401(k) Safe Harbor New Comparability Allocated Profit Sharing Plan
For companies with a few older, non-targeted employees, it’s often possible to design a combined program that minimizes the impact of those older employees. This plan design may result in a high percentage of the annual contributions funding the retirement benefits of the targeted employees.
A cash balance plan is a defined benefit plan that defines the benefit in terms that are more characteristic of a defined contribution plan. In other words, a cash balance plan defines the promised benefit in terms of a stated account balance.
In a typical cash balance plan, a participant's account is credited each year with a pay credit (such as 5 percent of compensation from his or her employer) and an interest credit (either a fixed rate or a variable rate that is linked to an index such as the one-year Treasury bill rate). Increases and decreases in the value of the plan's investments do not directly affect the benefit amounts promised to participants. Thus, the investment risks and rewards on plan assets are borne solely by the employer.
Cash Balance Plans can be combined with a Defined Contribution Plan (such as a 401(k) or a 401(k) Profit Sharing Plan). The advantage to this method is contributions to the DC plan may result in more favorable testing than if they were made to a stand-alone Cash Balance Plan. Because of this, the “two plan” approach is much more favorable to the plan sponsor.
This program combines a 401(k) New Comparability Profit Sharing Plan and a Cash Balance Plan. The basic contributions under the program begin with the following:
• The 401(k) portion of the Plan allows for Employee Deferral up to IRS imposed limits.
• The Profit Sharing Plan component may allocate up to 6% of total eligible payroll.
• Non-targeted participants under the Cash Balance Plan can accrue a 0.5% of pay per year of participation retirement benefit, and up to the DB maximum benefit accrual for the owners.
The plan contributions are subject to special discrimination testing, so the actual formulas will depend on company demographics. In some cases the allocation to the non-targeted employees may be higher.
The combined total company contribution to this program is the greater of 31% of pay or the cost for the DB/Cash Balance plan plus 6% of pay. So, this design is not optimal for many smaller employers (e.g., one owner and 2 other employees). Normally a business with 8 or more employees is the ideal size for this Plan design.
In addition, since the individual limit of $49,000 does not apply to the accruals under the Cash Balance Plan part of this program, it is an excellent program for many successful small employers who want to set aside more than this amount for their retirement.
SIMPLE IRA Plans allow employees to contribute a percentage of their salary each paycheck and require employer contributions. The employee contribution limit for 2010 is $11,500. The employer must contribute a matching contribution equal to 3% of pay or make a fixed contribution of 2% of compensation for all eligible employees.
Simplified Employee Pensions (SEP) allow employers to set up a type of IRA for themselves and each of their employees. Employers must contribute a uniform percentage of pay for each employee, although they do not have to make contributions every year. SEPs have low start-up and operating costs and can be established using a two-page form.
