10/17/2016. Establishing a New Defined Benefit Plan: From A to Z. Norman Levinrad, EA, FSPA, MAAA Summit Benefit & Actuarial Services, Inc.

Transcription

1 Establishing a New Defined Benefit Plan: From A to Z Norman Levinrad, EA, FSPA, MAAA Summit Benefit & Actuarial Services, Inc. 1

2 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. 2

3 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 3

4 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. 4

5 Design for Flexibility You are designing a CB plan for a partnership with two partners. They expect $500k of K-1 income each for 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? 1000 hours? Prorated? Accrual Requirements 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. 5

6 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. 6

7 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. 7

8 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 8

9 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. 9

10 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 10

11 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 11

12 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 November 5-6, 2015 Ultimate Cash Balance Seminar 23 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. November 5-6, 2015 Ultimate Cash Balance Seminar 24 12

13 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. November 5-6, 2015 Ultimate Cash Balance Seminar 25 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 November 5-6, 2015 Ultimate Cash Balance Seminar 26 13

14 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. November 5-6, 2015 Ultimate Cash Balance Seminar 27 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. 28 November 5-6, 2015 Ultimate Cash Balance Seminar 14

15 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. November 5-6, 2015 Ultimate Cash Balance Seminar 29 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. November 5-6, 2015 Ultimate Cash Balance Seminar 30 15

16 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. November 5-6, 2015 Ultimate Cash Balance Seminar 31 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. November 5-6, 2015 Ultimate Cash Balance Seminar 32 16

17 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. November 5-6, 2015 Ultimate Cash Balance Seminar (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. November 5-6, 2015 Ultimate Cash Balance Seminar 34 17

18 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! 18

19 Questions? 19