powerpoint presentation outlines...•if the prior example was redone using 3%, the result is...

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Workshop 5Advanced DB & Combo Testing

Lawrence Deutsch Larry Deutsch Enterprises

Kurt F. Piper

Piper Pension & Profit Sharing

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Cash Balance – Small Plan• Topics to cover

– Simple Cash Balance Only Plan

– EBAR for 401(a)(26)

– EBAR for 401(a)(4)

– Target Normal Cost

– Variation from Hypothetical Interest rate

– Multiple Hypothetical Interest rates

– DB/DC

– EBAR for gateway

– Primarily DB

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Cash Balance – Small Plan

Name Age Comp

Elizabeth 54 260,000

George 44 100,000

Edward 24 30,000

Victoria 24 30,000

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Simple Cash Balance Only Plan

• The features in a simple cash balance plan are pay credit and interest credit

• The benefits must satisfy 401(a)(4)

• The plan must satisfy 401(a)(26) and 410(b)

• If Top Heavy, must include Top Heavy minimum

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• The first question is benefit level for Elizabeth– Assume that Elizabeth wants a maximum benefit

– With retirement age 62, here maximum accrual in the first year would be $1,750

– Based upon 5.5% interest post retirement, 2014 417(e) mortality, that would be a lump sum at 62 of $261,216

– Discounting for 8 years from 62 to 54 at 5% would produce a maximum lump sum at age 54 of $176,801 (which we will round to $175,000)

– What if the Normal Retirement Age is 65, what is the maximum lump sum at 62?

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• The first question is benefit level for Elizabeth

– We will assume NRA of 62

– Pay credit of $175,000 for Elizabeth

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• The second question is interest crediting rate

– For now assume 5% (will come back to later)

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• The third question is benefit level to satisfy 401(a)(26)

– Based upon the Paul Shultz letter, 401(a)(26) requires that an individual needs to have a Normal EBAR (but based upon NRA rather than testing age) of at least .5%

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• Since there are 4 non-excluded employees, and at 4 non-excludable employees 401(a)(26) would require 40% coverage

• 40% of 4 would require 2 employees to have an EBAR of at least 0.5%

• Since Elizabeth would clearly be above 0.5%, need only 1 additional employee

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EBAR for 401(a)(26)• The Normal EBAR is defined as the increase in the

411(a)(7) accrued benefit during the measurement period divided by the years during the measurement period and divided by the average compensation

• The 411(a)(7) is defined as the benefit payable (under the terms of the plan) as an annuity at normal retirement age

• As Notice 96-8 points out, since the benefit at NRA would include indexing to NRA, the 411(a)(7) accrued benefit would be the current account balance, increased with indexing to NRA, and converted to an annuity

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EBAR for 401(a)(26)

• In the first year, the account balance equals the pay credit

• Assume that the average compensation for testing equals the current compensation

• Then, the formula for the EBAR would be

• EBAR = Pay credit * 1.05 ^ (62-age)/ plan 62 APR / comp

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EBAR for 401(a)(26)• EBAR = Pay credit * 1.05 ^ (62-age)/ plan 62 APR /

comp• If the EBAR =.5% then• Pay credit =.5% * comp * plan 62 APR / 1.05 ^ (62-

age)• Thus, if we want EBAR for Edward to have an EBAR of

0.5% (and the plan 62 APR is 12.5) then• Pay credit = .5% * $30,000 * 12.5 / (1.05 ^ (62-24)• Pay credit = $294

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EBAR for 401(a)(4)• The next issue is passing 401(a)(4)• Because there is only 1 HCE, there would be only 1 rate

group• Assuming that the plan satisfies the average benefit

percentage test, then the rate group would need to have a ratio percentage of at least the midpoint between the safe harbor and the unsafe harbor

• The concentration percentage is number of non-excludable of NHCE divided by the number of all non-excludable employees, i.e. ¾ = 75%

• The safe harbor percentage = 50% - ¾ of excess of concentration percentage over 60%, or 50-.75 * (75% -60%) = 38.75%

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EBAR for 401(a)(4)

• If the safe harbor percentage is 38.75%, then the unsafe harbor percentage is 28.75%, and the midpoint is 33.75%

• To have a ratio percentage of at least 33.75% would require 33.75% * 3 = 1.0125 or 2 employees

• Thus would need 2 (for our purposes the 2 24 year old) employee to have both a normal and most valuable benefit at least as large as the normal and most valuable EBAR for the HCE

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EBAR for 401(a)(4)

• As explained earlier, the normal EBAR is

• EBAR = Pay credit * 1.05 ^ (62-age)/ plan 62 APR / comp

• So for Elizabeth, her Normal EBAR would be

• EBAR = $175,000 * 1.05^ (62-54)/12.5/$260,000 = 7.96%

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EBAR for 401(a)(4)• The Most Valuable EBAR is determined by calculating

the normalized joint and survivor benefit payable at every possible payment age between the current age and testing age, selecting the highest, and determining the EBAR based upon that normalized benefit

• The immediately payable joint and survivor benefit (we will assume) is the current account balance divided by a Joint and Survivor factor based upon plan rates. Further assume (which is almost universally the case in cash balance plans) that the most valuable benefit is the one payable at the current age

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EBAR for 401(a)(4)• Normalizing is determining the actuarial equivalent of a

benefit as a life only benefit at testing age• So the normalized benefit=Account / APR QJSA plan *

APR QJSA test * (1+test rate) ^ (test age – curr age) / APR LO test

• Where• APR QJSA plan is the factor for the QJSA at current age

plan rates• APR QJSA test is the factor for the QJSA at current age

testing rates• APR LO test is the factor for the life only at testing age

testing rates

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EBAR for 401(a)(4)

• For Elizabeth, this works out as

• Normalized benefit = $175,000 / 15.7 * 11.2 * 1.085^(62-54) / 8.5

• Normalized benefit = $28,208

• The MV EBAR is then this normalized benefit divided by years in the measurement period and average compensation

• MV EBAR = $28,208 / $260,000 = 10.85%

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EBAR for 401(a)(4)

• We need the normal and MV EBAR to be at least as large for Edward and Victoria

• Thus, if we want EBAR for one of the 24 year olds to have an EBAR of 7.96% then

• Pay credit = 7.96% * $30,000 * 12.5 / (1.05 ^ (62-24)

• Pay credit = $4,672

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EBAR for 401(a)(4)

• The resulting MV EBAR would work as follows



• The MV EBAR is then this normalized benefit divided by years in the measurement period and average compensation

• MV EBAR = $8,224 / $30,000 = 27.41%

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EBAR for 401(a)(4)

• Thus, Edward and Victoria would be in Elizabeth’s rate group

• George would only need a large enough allocation so that top heavy is satisfied

• For simplicity, assume that all three NHCE are give a pay credit of $4,750

• This would produce the following allocation

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EBAR for 401(a)(4)

Name Comp Pay Credit

Elizabeth 260,000.00 175,000

George 100,000.00 4,750

Edward 30,000.00 4,750

Victoria 30,000.00 4,750

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Target Normal Cost• The determination of the Target Normal Cost (or

Funding Target) is consistent with any other benefit, i.e. determine the anticipated benefit at each possible decrement point, and discount it using the applicable segment rate.

• Assuming 100% probability of a lump sum, and 100% probability of payment at NRA the expected payment is straight forward

• For Elizabeth the expected payment would be the lump sum associated with the pay credit of $175,000 in 8 years when she is 62, i.e. $175,000 * 1.05 ^ 8 = $258,555

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Target Normal Cost

• This payment would be in 8 years, so subject to the second segment rate.

• Assuming that for 430 purposes, the second segment rate is 5.62%, the 430 Target Normal Cost would be $166,949

• Assuming that for 404 purposes, the second segment rate is 4.05%, the 404 Target Normal Cost would be $188,198

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Variation from Hypothetical Interest rate

• A major concern is what happens if the actual return on assets is either higher or lower than the hypothetical interest rate– Higher creates an issue of who the higher return

belongs to

– Lower creates an issue of the plan “guaranteeing” a higher rate of return than the plan might actually perform

– Actual has fallout if the rate is extremely low or high in a particular year

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Multiple Hypothetical Interest rates

• A somewhat unexplored solution is to use a different rate for HCEs than NHCEs, for example only guaranty 3% for HCEs, but 5% for NHCEs

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Multiple Hypothetical Interest rates• If the prior example was redone using 3%, the

result is requiring higher contributions for the NHCE

• The first thing is that using a lower interest rate does not increase the maximum immediate lump sum, so assume that the pay credit remains at $175,000

• EBAR = $175,000 * 1.03^ (62-54)/12.5/$260,000 = 6.82%

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• This creates a pay credit for Edward of

• Pay credit = 6.82% * $30,000 * 12.5 / (1.05=3 ^ (62-24)


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• If instead the interest credit for NHCE is the lesser of the 430 third segment rate or 6% (i.e. currently 6%)

• This creates a pay credit for Edward of

• Pay credit = 6.82% * $30,000 * 12.5 / (1.06 ^ (62-24)


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Multiple Hypothetical Interest rates• This produces three conclusions

– Given a fixed budget, higher interest crediting rates shift the benefits from short service to longer service employees

– Given a fixed target for HCE, higher interest crediting rates lower the NHCE benefits

– Given a fixed target for HCEs, lower interest rates for HCEs and higher interest rates for NHCEs further lowers benefits for NHCEs

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DB/DC• The more common design is to use a combination of

a DB/DC plan

• After complying with 401(a)(26) (as described earlier), a DC plan can be established to pass 401(a)(4)

• Unlike in a DB only situation where the controlling factor is the normal EBAR, in a DB/DC the controlling factor is the MV EBAR

• Recall that Elizabeth’s MV EBAR is 10.85%

• Recall that the pay credit for Edward and Victoria to pass 401(a)(26) is $294

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DB/DC• The MV EBAR in the DB plan for Edward and Victoria

would be• Normalized benefit = $294 / 18.1 * 12.2 * 1.085^(62-

24) / 8.5• Normalized benefit = $518• The MV EBAR is then this normalized benefit divided

by years in the measurement period and average compensation

• MV EBAR = $518 / $30,000 = 1.73%• That leaves an EBAR of 10.85% - 1.73% = 9.12% that

needs to be provided by the DC plan

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DB/DC

• Similar to the determination of the pay credit the allocation is determined as

• Allocation = 9.12% * $30,000 * 8.5 / (1.085 ^ (62-24)

• Allocation = $1,048

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EBAR for Gateway

• This would produce an allocation of less than 7.5% of pay, requiring a minimum allocation gateway

• To determine the equivalent allocation, the normalized benefit must be determined (as for other EBARs) and then converted to an equivalent present value (based upon testing assumptions) as a percent of pay

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EBAR for Gateway

• Equivalent Contribution Percentage = Pay Credit * (1 + Hyp Int Rate) ^ (test age – curr age) / APR plan * APR testing / (1 + test rate) ^ (test age –curr age)/curr compensation

• For Elizabeth this would be

• Equivalent Contribution Percentage = 175,000 * 1.05 ^ (62-54) / 12.5 * 8.5 / 1.085 ^ (62-54) /260,000 = 35.21%

• Note 175,000 / 260,000 = 67.31% of pay

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EBAR for Gateway

Name Age Comp Pay Credit ECP

Elizabeth 54 260,000 175,000 35.21%

George 44 100,000 294 0.11%

Edward 24 30,000 294 0.19%

Victoria 24 30,000 294 0.19%

NHCE Ave 0.16%

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EBAR for Gateway

• Since the HCE ECP is in excess of 35%, the minimum allocation percentage would be 7.5%

• Since the average ECP for NHCEs is 0.19%, that means that the DC plan would have to have a minimum allocation of 7.31%

• This makes the benefits look like this

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EBAR for Gateway

Name Pay Credit Allocation Total

Elizabeth 175,000 0 175,000

George 294 7,310 7,604

Edward 294 2,193 2,487

Victoria 294 2,193 2,487

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Primarily DB

• Another alternative (which works better on larger plans) is to be primarily DB in nature

• Edward and Victoria need a total MV EBAR of 10.85%

• So, if the DB plan provides an EBAR of 6% and the DC plan provides an EBAR of 5% then the plan would be primarily DB in nature

• The problem is that primarily DB in nature is measured on the normal, not most valuable EBAR

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Primarily DB

• This can be solved with the following formlas

• DB MV EBAR + DC EBAR = 10.85%

• DB Normal EBAR = DC EBAR

• DB MV EBAR / DB Normal EBAR = 27.41% / 7.96% (as calculated earlier, and noting the ratio is constant)

• So DB MV EBAR = 3.44 * DB Normal EBAR

• So 3.44 DB Normal EBAR + DB Normal EBAR = 10.85%

• So DB Normal EBAR = 10.85 / 4.44 = 2.44%

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Primarily DB

• If the DB Normal EBAR = 2.50% (rounded up so DB is larger than DC)

• Pay credit = 2.50% * $30,000 * 12.5 / (1.05 ^ (62-24)


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Primarily DB• MV EBAR would be



• MV EBAR = $2,584 / $30,000 = 8.61%

• So DC EBAR = 10.85% - 8.61% = 2.24%

• So Allocation = 2.24% * $30,000 * 8.5 / (1.085 ^ (62-24)

• Allocation = $257

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Primarily DB• So while the MV EBAR is high enough, the

Normal EBAR is not

• So the testing would turn on the Normal EBAR

• The DB EBAR + DC EBAR = 7.96%

• If the DB EBAR =4.00% and DC EBAR =3.96% this will worked

• Remember the DB EBAR must be greater than the DC EBAR

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Primarily DB• If the DB Normal EBAR = 4.00% (rounded up

so DB is larger than DC)

• Pay credit = 4.00% * $30,000 * 12.5 / (1.05 ^ (62-24)


• DC EBAR = 3.96%

• So Allocation = 3.96% * $30,000 * 8.5 / (1.085 ^ (62-24)

• Allocation = $455

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Primarily DB

Name Pay CreditAllocationTotal

Elizabeth 175,000 0 175,000

George 0 5,000 5,000

Edward 2,349 455 2,804

Victoria 2,349 455 2,804

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Primarily DB

• The removal of the minimum allocation gateway, particularly for the higher paid NHCE who is not making the plan work can be substantial

• The Top Heavy minimum is 5% in DC for George and Edward and Victoria have a benefit in the DB plan just barely in excess of 2% of pay (note normal EBAR is more than 2% of pay)

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Primarily DB

• This actually works better with larger groups, and if there are HCEs excluded from the plan

• In such a plan, the DB plan could have a number of people in the DB plan at 0.5% of pay (for 401(a)(26) who are not needed to pass 401(a)(4), and so, with no DC benefit, have a higher DB benefit

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Primarily DB

• Consider a plan with 20 HCEs and 80 NHCEs that wants to benefit 5 of the 20 HCEs

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Primarily DB

• 401(a)(26) requires the plan to cover the lesser of 40% of the non-excludable employees or 50

• So would need to cover 40 employees

• Since covering 5 HCEs would cover 35 NHCEs

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Primarily DB• Assume plan uses 70% ratio percentage test

for 410(b)

• Plan covers 5 out of 20 NHCEs (or 25%)

• So plan would need to cover 70% of 25% of 80 NHCEs

• Or 14 NHCEs

• Since already need to cover 35 NHCEs plan would pass 410(b)

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Primarily DB

• The concentration percentage would be 80/100 = 80%

• The safe harbor percentage would be 50% - ¾* (80%-60%)=35%

• The unsafe harbor percentage would be max(20%,35%-10%)=25%

• The midpoint would be (35%+25%)/2=30%• The rate group with 5 HCEs would need 30% of

25% of 80• Or 6 NHCEs

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Primarily DB• So a plan design that covers 35 NHCEs in the DB

plan (receiving at least 0.5% of pay)

• Plus 6 of those 35 in a DC plan with an EBAR sufficient to satisfy rate group testing (as described above)

• Would satisfy

– 401(a)(26)

– 410(b)

– 401(a)(4)

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Primarily DB

• Because 35-6 = 29 of the NHCEs would have higher DB benefits (because they have no DC benefits) and

• Because 29 is more than half of 35

• The plan is primarily DB in nature and has no minimum allocation gateway

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Primarily DB• Assuming that the plan is Top Heavy (and how could it

not) then• Add a second DC plan and provide a DC allocation of 5%

of pay in the DC plan for the 29 NHCEs not in the first DC plan

• The 5 HCEs could be added to this second DC plan and provided a DC benefit on a cross tested basis

• Because (as pointed out before) a plan would need 14 NHCE to pass 410(b), this plan would pass 410(b)

• The DC plan would need to NOT be aggregated with the DB plan for testing (because then the plan may fail to be primarily DB)

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Primarily DB

• If the plan sponsor wants a 401(k) plan as an employee benefit, if the key employees are not eligible in the 401(k) plan (and their benefits are transferred out if already in the 401(k) plan) then the 401(k) plan would not be top heavy

• The 5% top heavy minimum (from DC plan two) cannot be provided in the 401(k) plan, because a plan that provides the top heavy minimum is part of the top heavy aggregation group, so the 401(k) plan must be a third DC plan

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Primarily DB

• If the plan sponsor wants the 401(k) plan to be a safe harbor (with a 3% QNEC) the contribution in the first and second DC plan can be used because the 3% QNEC does not have to be in the 401(k) plan

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Another ExampleEmployee Data

Name Age Compensation

Owner 1 47 260,000

Owner 2 65 260,000

Owner 3 38 260,000

Owner 4 59 260,000

Owner 5 48 260,000

Owner 6 49 260,000

NHCE Staff Avg 45 658,000

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Example

• Calendar plan year, 2014

• 6 Owners

• 24 NHCE Staff Employees

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Design #1 – 401(k) Profit Sharing Plan

• All owners are receiving $34,500 profit sharing and $17,500 401(k) deferrals (plus $5,500 catch up if applicable)

• All NHCE’s included and receiving 7.30% to pass nondiscrimination testing

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Design #1 – Cash Balance Plan

• Owner 1 receiving $60,000 pay credit

• Owners 4 and 5 receiving $110,000 pay credit

• All NHCE’s included and receiving 2.50% to pass 401(a)(26).

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Design #1 – Testing

• Plans aggregated for testing

• Annual testing

• Plan Year Compensation

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Design #1 - Results

Name Age PS Credit CB Credit Total401(k)

Deferrals

Owner 1 47 34,500 60,000 94,500 17,500

Owner 2 65 34,500 0 34,500 23,000

Owner 3 38 34,500 0 34,500 17,500

Owner 4 59 34,500 110,000 144,500 23,000

Owner 5 48 34,500 110,000 144,500 17,500

Owner 6 49 34,500 0 34,500 17,500

NHCE Staff Avg 45 48,034 16,450 64,484 11,924

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Design #1 – Results

• Total cost for owners (including their deferrals) is $667,484

• Owners are receiving a total allocation of $603,000 (or 90.34%)

• Staff cost = $64,484

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Design #2 – Testing

• Plans aggregated for testing

• Annual testing

• Average compensation

– Significant number of employees hired in 2012 so this improves testing results

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Design #2 – 401(k) Profit Sharing Plan

• All owners are receiving $34,500 profit sharing and $17,500 401(k) deferrals (plus $5,500 catch up if applicable)

• All NHCE’s included and receiving 6.40% to pass nondiscrimination testing (reduced from 7.30% in Design #1)

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• Owner 1 receiving $60,000 pay credit

• Owners 4 and 5 receiving $110,000 pay credit

• All NHCE’s included and receiving 2.50% to pass 401(a)(26).

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Design #2


Deferrals

Owner 1 47 34,500 60,000 94,500 17,500

Owner 2 65 34,500 0 34,500 23,000

Owner 3 38 34,500 0 34,500 17,500

Owner 4 59 34,500 110,000 144,500 23,000

Owner 5 48 34,500 110,000 144,500 17,500

Owner 6 49 34,500 0 34,500 17,500

NHCE Staff Avg 45 42,112 16,450 58,562 11,924

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Design #2 – Results



• Staff cost = $58,562 (decrease of approx. $6,000 from Design #1)

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Design #2 – Observations

• Contributions reflected for NHCE’s are required to satisfy DC/DB minimum gateway

• If DC/DB minimum gateway was lower, could consider other options:– Accrued to date testing

– Flat $ profit sharing or cash balance allocation

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• 6 HCE’s and 24 NHCE’s; 3 HCE’s are benefiting in the cash balance plan

• To pass IRC 401(a)(26), CB plan needs to cover at least 12 employees (40% of 30); since 3 HCE’s are covered, plan needs to cover at least 9 NHCE’s.

• Assuming all 9 NHCE administration employees would receive a .5% allocation in the DB plan. Annual cost is based on present value using IRC 417(e) segment rates.

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• Could consider cash balance allocation for NHCE’s (either % of pay or flat $) vs. .5% traditional DB accrual

• Issues to consider

– Traditional DB subject to IRC 417(e)

– Vesting requirements for CB plans

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Design #3 – DC Plan 1

• Assuming the ratio test for IRC 410(b) – plan covers 3 out of 6 HCE’s (50%) so it needs to cover 70% of 50% of 24 NHCE’s (or 8.4, rounded up to 9)

• Since we’re already covering 9 for 401(a)(26), passes 410(b)

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• For rate group testing, the midpoint would be 30%; a rate group of 3 HCE’s would need 30% of 50% of 24 (or 4 NHCE’s)

• 4 NHCE’s are receiving a 5.5% allocation in order to satisfy rate group testing

• No HCE’s are benefiting in DC Plan 1

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Design #3 – Primarily DB

• So a plan design covering 9 NHCE’s in the cash balance plan (with at least .5% of pay) plus 4 of those in a DC plan with an EBAR sufficient to pass rate group testing would satisfy IRC 401(a)(26), IRC 410(b) and IRC 401(a)(4)

• Because 9-4=5 of the NHCE’s would have a higher DB benefit (because they have no DC benefit) and 5 is more than ½ of 9, the plan is primarily DB in nature and has no minimum gateway requirement

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• Assuming that the plan is top heavy, a second DC plan is added to provide at least 5% to all NHCE’s participating in the cash balance plan

• Second DC plan includes a 401(k) feature and 3% non-elective safe harbor contribution

• The second DC plan would not be aggregated with the DB plan for testing (because then it may fail to be primarily DB)

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• Assuming all 6 HCE’s are receiving the maximum DC benefit, at least 70% of 24 (or 17 NHCE’s) would need to benefit in order to pass IRC 410(b).

• All 20 NHCE’s not in the first DC plan would receive a benefit in the second DC plan.– Those not participating in the DB plan would receive the

4.42% minimum gateway and all others would receive 5% to satisfy the top heavy minimum

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Design #3 - Results


Deferrals

Owner 1 47 34,500 60,000 94,500 17,500

Owner 2 65 34,500 0 34,500 23,000

Owner 3 38 34,500 0 34,500 17,500

Owner 4 59 34,500 110,000 144,500 23,000

Owner 5 48 34,500 110,000 144,500 17,500

Owner 6 49 34,500 0 34,500 17,500

NHCE Staff Avg 45 23,867 7,810 31,677 11,924

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Design #3 - Results



• Staff cost = $31,677 (decrease of approx. $27,000 from Design #2)

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Additional Concepts• There are some who consider the traditional

“401(a)(26) special” plan design as optimal.

• Consider a July 31 plan year end to ensure closeout can be done before accrual for year.– DB/DC requires same plan year end

– Off-calendar 401(k) may be a complication

• Remember that DC is “use it or lose it”, while DB is not

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powerpoint presentation outlines...•if the prior example was redone using 3%, the result is...

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