establishing a new defined benefit plan: from a to z

10/17/2016

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Establishing a New Defined Benefit Plan: From A to Z

Norman Levinrad, EA, FSPA, MAAA

Summit Benefit & Actuarial Services, Inc.

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Assumptions

• We are designing a small DB plan.

• Large plan design is down the hall three doors to your left.

Plan Design Rules

– Clearly understand the client’s objectives.

– Determine what plan they currently have in place and know the provisions of that plan.

– Find out if there was ever a prior DB plan.

– Establish all ASG and/or CG issues.

– Gather projected census data for the upcoming year.

– Don’t leave out any of the prior steps. You can’t do a decent analysis without all this info. or else it blows up later.

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The Proposal• What do you show the client?• Show numbers only? No!• Have a proposal that explains:

– How the DB or CB plan works– Limitations, frequency of amendments etc.– If its CB plan, explain coordination of crediting rate and

investment policy.– If it’s a DB plan, explain the impact of volatility.– Explain what happens if an HCE terminates, possible

benefit restrictions etc.

– Ask the client to share the proposal with the CPA so everyone one is on the same wave-length.

DB or CB?

• If it’s an owner only or owner spouse plan, is there any reason for it to be a CB plan?

• No difference in contribution or distribution amounts.

• No document differences any more….for the most part.

• Can minimize RMDs more effectively in a traditional DB with 2/20 vesting and service before the effective date excluded than with the 3 yr cliff schedule in a CB plan.

• What approach makes more sense? See next slide

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Design for flexibility

• For example, an owner only situation wants a DB plan with a contribution of $100,000 a year.

• Do you:– Design a traditional DB formula such that the

minimum is $100k?– Design a traditional DB formula such that the

maximum is $100K?– Design a traditional DB formula such that $100k is in

the middle of the range (assuming they have past service)?

– Design a CB plan with a credit of $100k?

Design for Flexibility – Sole Props and Partnerships

• A credit that exceeds the Sch C or K-1 could be an issue because it could create a required contribution that cannot be deducted if you use a flat $ amount.

• You could define a credit as $100,000 but not to exceed 90% of net Sch C/K-1 income.

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Design for Flexibility• You are designing a CB plan for a partnership with two

partners. • They expect $500k of K-1 income each for 2016. • Their goal is a CB credit of $150k each (assume this is

within the 415 limit)• Do you:

– Design a CB credit of $150k? What happens if their income tanks?

– Design a CB credit of $150k not to exceed 57% of Plan Comp?

– Design a CB credit of $150k not to exceed 30% of earned income?

Accrual Requirements

• 1000 hours?

• Prorated?

• Discuss advantages of each with client – effect on shareholders who leave mid year and effect on funding policy and ability to pay unrestricted lump sums.

• Credits or benefits can’t be decreased once accrued.

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Tiers• Always add a separate tier for rank and file

employees, even if there aren’t any.• Example: Dr. Specialist Cohen has no employees

and wants a DB plan. You design a DB plan for her for 2016 with a formula of $1750 per YOP max 10. In 2017 you find out she hired an employee who entered the plan 7/1/17. Oops! You should have had used two tiers, one for Cohen at $1750, and one for the employees at a deminimus level (yes I know, it will have to pass 401a and satisfy TH if there is no PS plan).

Tiers• Always define tiers carefully and have document

language that says someone’s status in a tier is based on their status as of the first day of the plan year.

• Make sure you ask the questions each year to correctly determine status in a tier.

• Example: Use “Shareholders without regard to attribution” rather than “Shareholders” etc.

• Use a name rather than a title if possible.• Exclude principals by name rather than have

them in a tier at a $0 benefit.

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Tiers by Name

• Can you? Yes, there is no issue with similarly situated employee rule. Dr. Donovan cannot be similarly situated to Dr. Levinrad.

• Should you?

• Will you? Yes you often will – because you will have to.

• Does it raise cash or deferral issues?

– How are credits determined?

• Managing expectations is very challenging when the plan is designed this way if there are multiple shareholders.

Expect the Worst

• After you have created a design, ask yourself: what’s the worst thing that can happen with this design?

– Because it will inevitably happen.

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What’s the worst that can happen?

• Look at your design and think about the things that can blow it up.

• For example, using final average comp for a sole prop can blow up a design where they choose not to make a contribution in a year, which increases their AMC which increases their TNC and minimum required contribution.– Always use a flat $ formula for sole props!

What’s the worst that can happen?• What factors are built into your design that

can cause an undesirable result in future years?

• Many times this is unavoidable given the design required to meet initial objectives.

• For example the flat $ formula in our prior example could require too high a minimum required contribution in future years if their Net Sch C income drops etc…

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Design to meet a client’s specific goals• Ask: How much money do you need to make

to live on before you make a pension contribution and design for that:

• Example: – Client says they need $100,000 a year to live on

before they make any substantial pension contribution and would like to shelter 75c for each dollar they make above that.

– Use a CB plan with a credit of 1% of comp up to $100,000 plus 3x comp in excess of $100,000.

S-corps

• Define a credit as a % of comp in excess of a certain amount, for example:

– CB credit = 25x comp in excess of $100,000

– So if comp = $105,000, CB credit = $125,000

– Allows an S-corp owner to select W-2 comp to generate a desired credit. CPA should determine appropriate W2 comp amounts.

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PBGC covered– DB plans exempt from PBGC coverage

• Plans of professional group if plan never covered more than

25 active participants

– Physicians, dentists, D.O.s, O.D.s, lawyers, CPAs, P.E.s,

architects, actuaries, others where license requires “advance

study”

» Not APAs, QPAs, RIAs, real estate prof, etc.

– ERISA 4021(b)(13), 4021(c)(2)

• Plans covering only substantial (more than 10%) owners

– Attribution rules of IRC 1563(e) apply

– ERISA 4021(b)(9), 4021(d)

PBGC covered

• Does it ever make sense to choose to be PBGC covered to take advantage of no combined deduction limit?

– Premiums

– Inability to terminate if no majority owners to forgo benefits

– Post termination audits

– Reportable events

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What Design Avoids Things Going Bad?

• Keep it Simple

• Always ask yourself: “what’s the worst that can happen and how would this design deal with it?”

• Don’t design for year 1 only.

• Make sure clients understand the mechanics of benefits testing…that favorable results usually depend on the youngest participants.

• Use the same Eligibility Requirements and Entry Dates for all sources of money

• Use total compensation for all purposes

• Use individual allocation groups with 1 hour and no end of year employment requirement for Profit Sharing allocations

Problems with Multiple Shareholders...

• If a CB plan covers multiple shareholders, and one leaves the practice when assets don’t cover the liabilities then:– The departing shareholder may be restricted from

getting a lump sum

– Remaining shareholders are left responsible for the losses

– Everyone is grumpy

– This is the big disadvantage of any DB or CB plan covering multiple shareholders

November 5-6, 2015 Ultimate Cash Balance Seminar 22

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Crediting Actual ROR!• Can use:

• Actual return on plan assets on all or a

subset of assets

• Portfolio must be diversified

• Subset of assets?

• Investment Return on Mutual Funds

• Must be broad-based

• Not significantly more volatile than US

markets, no industry sector funds


Crediting Actual ROR

• Why credit actual ROR? Generally the assets and liabilities

match each other so:

• If investment loss generally no make-up contributions

• So the investment risk is shifted to employees.

But…only partially, because the sponsor still has

some risk to the extent of the preservation of

principal rule which says that the CB account at the

time of distribution can not be less than cumulative

credits. It’s still a DB plan.


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Main Selling Point of ROR

• Avoids the situation when a shareholder leaves and there are losses…

• Except if losses are so big that the Preservation of Principal rule kicks in.

• But most of the time it avoids this problem.


But….

Remember, it’s still a DB plan.

415 limits are the same

Higher Rates of Return don’t mean a higher distribution.

And now the problems with it…


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Crediting Actual ROR –why not?

Final regs still did not address the major compliance issue with

actual rates of return, which is that you must project the interest

credit using the current crediting rate to determine the AB at

NRA for all statutory purposes. This causes many issues:

• Potentially harder to pass 401(a)(26)

• Potentially harder to pass 401(a)(4) – volatile PS

contributions to NHCEs to pass year by year

• Problems with 415 limits – could result in a lower 415 max

lump sum in a year with a high ROR in the prior year.


Managing the Uncertainty

• Despite the uncertainty, we can use a design which will avoid the statutory issues created by volatile variable crediting rates, and avoid the scenario where shareholders have to make up losses, or there are losses and a shareholder has terminated.

• For example, use the lesser of ROR or 5%.

• Good approach where no NHCEs? Some of the issues go away, but not all.

28November 5-6, 2015 Ultimate Cash Balance Seminar

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Example of a stable design

• There is a design approach that can work well even if there are NHCEs, that partially takes ROR into account; avoids the volatility in testing; and protects shareholders from losses.

• Consider a professional practice with multiple shareholders and a bunch of rank and file employees, with a generic CB design that provides one tier for the shareholder and a deminimus credit tier of the rank and file employees, and is tested together with as PS plan.


Example…

• Use CB crediting rates as follows: A fixed crediting rate of 5% for the rank and file employees; and uses actual ROR on assets but with a maximum of 5% for the shareholders.


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Example…• This design will accomplish the following:

– Stable CB credits to pass 401(a)(26) for the employees because of the fixed rate of 5% that applies to their balances.

– Stable 401(a)(4) testing because of the maximum 5% limit on the ROR for the shareholders;

– Stable 415 limits – no variation in the 415 dollar limitation because of different interest rates form year to year.

– Protects the shareholders from having to make up losses (as long as the hypothetical account value satisfies the Preservation of Principal rule) and protects the practice if a shareholder leaves.


Example…

• Under this approach, because of the 5% cap on the ROR for the shareholders, a trust that has higher rates of return may have surplus assets. If a shareholder leaves and feels they are entitled to a share of this surplus this will require either plan termination or an ad-hoc increase via amendment to allocate the surplus.


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One “little” problem…411(a)(9)

• This rule says that the annuity payable at any point cannot be less than any previously available amount.

• IRS require all CB plan documents to have this language.• Consider what this means in the context of a CB plan using

actual ROR when the ROR decreases. • Assume a participant has a CB account balance of $1.5

million at age 64. Assume under the plan’s actuarial equivalence factors this provides a life annuity of $10,074 per month.

• Now assume there is a big loss in the ROR and the participant has a CB account balance of $1m at age 65. Say this now provides a life annuity of $6,885 per month.


411(a)(9)

• Per the rule in 411(a)(9) the participant is still entitled to an annuity of $10,074 per month! If this participant quits and elects the annuity option, this would wreak havoc on the plan as the cost of the annuity would be maybe 50% more than the participant’s account balance. No one promoting plan designs using ROR is addressing how to deal with this issue, and given this we should all think carefully about using this design approach.


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At Plan Set Up

• Always get a written service agreement so you don’t get screwed and you don’t get sued.

• Don’t proceed with the plan document without all the confirmed Employer details.

• Talk with the financial advisor to make sure they understand how the DB plan works.

Things to communicate at plan set up!

• Give the client a written set of rules to follow:– Never take money out of the plan without written

instructions from you.– Never put money in the plan without written

instructions from you.– Never mix plan money with their personal or business

assets.– Don’t invest plan money in anything other than

stocks, bonds, or cash instruments without talking to you first.

– Never listen to anyone other than you in regards to the plan and to always call before they do anything!

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Questions?

• [email protected]

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