Hybrid Pension Retirement 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 operated retirement plans for their owner-executives and employees. Hybrid Retirement Plans present a economical and efficient solution.
LeagueFinancial has consistently developed plan designs that favor 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|
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:
CASH BALANCE & 401(k) PLAN CONTRIBUTION
|DOCTOR’S SHARE = 97%|
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.
|Age||Salary||New Comparability||Cash Balance|
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:
|Age||Salary||Allocation||% of Salary|
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 retirement 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.
About the Author: Paul M. League, QFP — QUALIFIED FINANCIAL PLANNER, is the Founding Principal of League Financial & Insurance Services (www.LeagueFinancial.com), which is a privately held company, established in 1984, and located in Palm Desert, CA. Paul and his company specialize in assisting clients to create, expand & preserve assets “…in a league of our own.” Contact Information: Paul M. League, P.O. Box 11800, Palm Desert, CA 92255-1800; 800.482.5347; Info@LeagueFinancial.com. © Paul M. League. All rights reserved.
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