PSP, Cash Balance and Defined Benefit Plans, Etc.


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401k/Profit Sharing Plan

In 1978, the Internal Revenue Code was amended to include Section 401(k), leading to perhaps the most common and well known form of employer- sponsored retirement savings plan. 401(k) plans allow for pre-tax deferral of compensation, as well as employer contributions, either as a “matching” component or as a profit sharing contribution. Roth accounts are also allowed in 401(k) plans. This is a result of the Economic Growth and Tax Relief Reconciliation Act of 2001, and made permanent by the Pension Protection Act of 2006. Contributions and distributions follow much of the same rules as Roth IRAs, but with life insurance and loans allowed, and the larger 401(k) limits on contributions.

Characteristics

  • Established by an employer
  • Employer contributions are discretionary up to 25% of eligible compensation
  • May be designed to have different contribution rates for different classes of employees
  • May be designed to favor older, highly compensated employees
  • Deferrals and contributions subject to discrimination testing
  • Pre-tax and after-tax deferrals allowed
  • Allows for catch-up contributions for those age 50 and older
  • May allow for rollovers and transfers from IRA’s and other eligible plans
  • May allow for plan loans
  • May include life insurance as a plan asset
  • May be combined with a defined benefit plan
  • Allowed to exclude certain classes of employees
  • May have a vesting schedule.

Gaps

  • Owners and other highly compensated individuals may not be able to contribute the maximum allowable by law due to low employee participation and deferral rates
  • Need a third party administrator to administer the plan and perform the necessary testing and governmental reporting
  • Participant bears the investment risk.

Best Utilization

  • Stable and Peak phases of the business life cycle
  • Businesses that have growth and employer wants to give employees the opportunity to save for their own retirement
  • Earnings are not always stable and owner wants to maintain contribution flexibility
  • Owner would like to provide different contributions for different job classifications

 

Cash Balance Plan

A cash balance plan is a variation of a defined benefit plan, seeking to combine the attributes of a defined contribution plan with a defined benefit plan. Each employee has a hypothetical account earning a fixed rate of interest on the employer’s contribution which is typically based upon a percentage of the employee’s earnings, to determine the employee’s retirement fund at retirement age. The rate of interest can vary from year to year.

Characteristics

  • Established by an employer
  • Termed a “hybrid” plan, blending attributes of a traditional defined benefit plan with a defined contribution plan
  • Provides a specific “contribution credit” and “interest credit” which are promised to the employee by the employer and set in the plan
  • May provide differing benefit formulas that may provide different benefits to different classes of employees
  • May be combined with a profit sharing 401(k) plan
  • Benefit is usually stated as a lump sum
  • Plans are typically based on a formula that considers pay in each year of participation (known as a “career average plan”)
  • Level funding provides for more stable contributions and makes it easier to budget for
  • May provide for substantial amounts of life insurance
  • Maximum contribution is determined by the amount needed to fund a defined benefit at normal retirement age, actuarially determined

Gaps

  • Older participants and those with many years of service have a less direct relation to income replacement needs than a plan that links benefits to final average pay
  • More expensive to administer compared to a defined contribution plan
  • Contribution is mandatory each year subject to minimum funding rules
  • Employer bears the investment risk

Best Utilization

  • Stable and Peak phases of the business life cycle
  • Owners in mid-career
  • Businesses with multiple owners of different ages
  • Businesses with up to 50 employees who wish to have more control of the cost to provide benefits to rank-and-file employees
  • Businesses wishing to tier benefits to different types of employees

 

Traditional Defined Benefit Plan

The defined benefit pension plan was once the predominant form of employer- sponsored retirement plan, providing a monthly retirement benefit determined based upon a formula that considered an employee’s earnings history, tenure of service and age. The advent of the 401(k) plan replaced the defined benefit plan as the predominant form of retirement plan, partly because of the less expensive cost of administration of a 401(k) plan and the shifting of the investment risk from the company to the individual participant.

Characteristics

  • Established by an employer
  • Contribution levels may be substantially higher than defined contribution plans
  • Favors older, highly compensated employees
  • May be provided along with a profit sharing 401(k) plan
  • May provide for substantial amounts of life insurance
  • Maximum contribution is actuarially determined by the amount needed to fund a defined benefit at normal retirement age
  • May have a tiered benefit formula which provides different benefits to different classes of employees.

Gaps

  • More expensive to administer compared to a defined contribution plan
  • Contribution is mandatory each year subject to minimum funding rules
  • Employer bears the investment risk

Best Utilization

  • Stable, Peak and Transfer phases of the business life cycle
  • Business owners who have increased earnings and stable cash flow
  • Business owners and highly compensated employees who are more focused on retirement (usually 10 to 15 years or sooner)
  • Businesses looking for increased tax deductions
  • Businesses where the youngest owners and key employees are seven or more years older than the oldest rank and file employee
  • Businesses wishing to provide different level of benefits to different types of employees
  • Owners looking to make up for lost time in accumulating retirement income

Owners and other highly compensated employees seeking a recovery plan due to market losses suffered by their other retirement accounts from economic down turns and recessions.

 

Fully Insured Defined Benefit Plan

A fully insured plan is a defined benefit plan that is funded solely with life insurance, annuity contracts or a combination of both. As a result of this funding, the employer has shifted the investment risk to the insurance company that provides the insurance and annuity contracts. This allows the plan to avoid many of the funding requirements of traditional defined benefit plans, as well as administration requirements. It also allows for larger contributions to be made making them very popular for small business owners who have relatively few years left until retirement.                                               

Characteristics

  • Established by an employer
  • Contribution levels may be substantially higher than other types of defined contribution plans
  • Favors older, highly compensated employees
  • May be combined with a profit sharing 401(k) plan
  • May provide for substantial amounts of life insurance
  • Maximum contribution is determined by the amount needed to fund a defined benefit at normal retirement age, using a guaranteed interest rate as set by the insurance company’s products
  • May be less expensive to administer than other defined benefit plans
  • Not subject to market volatility, no investment risk, no under- or over-funding.

Gaps

  • More expensive to administer compared to a defined contribution plan
  • Contribution is mandatory each year

Best Utilization

  • Stable, Peak and Transfer phases of the business life cycle
  • Business owners who have increased earnings and stable cash flow
  • Business owners and highly compensated employees who are more focused on retirement (usually 10 to 15 years or sooner)
  • Businesses looking for increased tax deductions
  • Businesses where the youngest owners and key employees are seven or more years older than the oldest rank and file employee
  • Owners looking to make up for lost time in accumulating retirement income
  • Owners and other highly compensated employees seeking a recovery plan due to market losses suffered by their other retirement accounts from economic down turns and recessions
  • Owners who are risk adverse