Cash Balance. Lawrence Deutsch Larry Deutsch Enterprises. Mark Dunbar DB&Z, Inc. Advanced Actuarial Conference, 6/2-6/3/2014

Transcription

1 Cash Balance Lawrence Deutsch Larry Deutsch Enterprises Mark Dunbar DB&Z, Inc. Advanced Actuarial Conference, 6/2-6/3/2014

2 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 2

3 Cash Balance Small Plan Name Age Comp Elizabeth ,000 George ,000 Edward 24 30,000 Victoria 24 30,000 3

4 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 4

5 Simple Cash Balance Only Plan 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, (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? 5

6 Simple Cash Balance Only Plan The first question is benefit level for Elizabeth We will assume NRA of 62 Pay credit of $175,000 for Elizabeth 6

7 Simple Cash Balance Only Plan The second question is interest crediting rate For now assume 5% (will come back to later) 7

8 Simple Cash Balance Only Plan 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% 8

9 Simple Cash Balance Only Plan 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 9

10 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 10

11 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 11

12 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 12

13 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 nonexcludable 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 * (75% - 60%) = 38.75% 13

14 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 = 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 14

15 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% 15

16 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 16

17 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 17

18 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% 18

19 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 19

20 EBAR for 401(a)(4) The resulting MV EBAR would work as follows Normalized benefit = $4,672 / 18.1 * 12.2 * 1.085^(62-24) / 8.5 Normalized benefit = $8,224 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% 20

21 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 21

22 EBAR for 401(a)(4) Name Comp Pay Credit Elizabeth 260, ,000 George 100, ,750 Edward 30, ,750 Victoria 30, ,750 22

23 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 23

24 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 24

25 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 25

26 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 26

27 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% 27

28 Multiple Hypothetical Interest rates This creates a pay credit for Edward of Pay credit = 6.82% * $30,000 * 12.5 / (1.03 ^ (62-24)) Pay credit = $8,318 28

29 Multiple Hypothetical Interest rates 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)) Pay credit = $2,794 29

30 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 30

31 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 31

32 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% % = 9.12% that needs to be provided by the DC plan 32

33 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 33

34 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 34

35 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 / ^ (62-54) /260,000 = 35.21% Note 175,000 / 260,000 = 67.31% of pay 35

36 EBAR for Gateway Name Age Comp Pay Credit ECP Elizabeth , , % George , % Edward 24 30, % Victoria 24 30, % NHCE Ave 0.16% 36

37 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 37

38 EBAR for Gateway Name Pay Credit Allocation Total Elizabeth 175, ,000 George 294 7,310 7,604 Edward 294 2,193 2,487 Victoria 294 2,193 2,487 38

39 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 39

40 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 = / 4.44 = 2.44% 40

41 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)) Pay credit = $1,468 41

42 Primarily DB MV EBAR would be Normalized benefit = $1,468 / 18.1 * 12.2 * 1.085^(62-24) / 8.5 Normalized benefit = $2,584 MV EBAR = $2,584 / $30,000 = 8.61% So DC EBAR = 10.85% % = 2.24% So Allocation = 2.24% * $30,000 * 8.5 / (1.085 ^ (62-24)) Allocation = $257 42

43 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 43

44 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) Pay credit = $2,349 DC EBAR = 3.96% So Allocation = 3.96% * $30,000 * 8.5 / (1.085 ^ (62-24)) Allocation = $455 44

45 Primarily DB Name Pay Credi AllocationTotal Elizabeth 175, ,000 George 0 5,000 5,000 Edward 2, ,804 Victoria 2, ,804 45

46 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) 46

47 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 47

48 Primarily DB Consider a plan with 20 HCEs and 80 NHCEs that wants to benefit 5 of the 20 HCEs 48

49 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 49

50 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) 50

51 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 51

52 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) 52

53 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 53

54 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) 54

55 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 55

56 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 56

57 Another Example Employee Data Name Age Compensation Owner ,000 Owner ,000 Owner ,000 Owner ,000 Owner ,000 Owner ,000 NHCE Staff Avg ,000 57

58 Example Calendar plan year, Owners 24 NHCE Staff Employees 58

59 Design #1 401(k) Profit Sharing Plan All owners are receiving $34,500 profit sharing and $17, (k) deferrals (plus $5,500 catch up if applicable) All NHCE s included and receiving 7.30% to pass nondiscrimination testing 59

60 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). 60

61 Design #1 Testing Plans aggregated for testing Annual testing Plan Year Compensation 61

62 Design #1 - Results Name Age PS Credit CB Credit Total 401(k) Deferrals Owner ,500 60,000 94,500 17,500 Owner , ,500 23,000 Owner , ,500 17,500 Owner , , ,500 23,000 Owner , , ,500 17,500 Owner , ,500 17,500 NHCE Staff Avg 45 48,034 16,450 64,484 11,924 62

63 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 63

64 Design #2 Testing Plans aggregated for testing Annual testing Average compensation Significant number of employees hired in 2012 so this improves testing results 64

65 Design #2 401(k) Profit Sharing Plan All owners are receiving $34,500 profit sharing and $17, (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) 65

66 Design #2 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). 66

67 Design #2 Name Age PS Credit CB Credit Total 401(k) Deferrals Owner ,500 60,000 94,500 17,500 Owner , ,500 23,000 Owner , ,500 17,500 Owner , , ,500 23,000 Owner , , ,500 17,500 Owner , ,500 17,500 NHCE Staff Avg 45 42,112 16,450 58,562 11,924 67

68 Design #2 Results Total cost for owners (including their deferrals) is $661,562 Owners are receiving a total allocation of $603,000 (or 91.15%) Staff cost = $58,562 (decrease of approx. $6,000 from Design #1) 68

69 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 69

70 Design #3 Cash Balance Plan 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. 70

71 Design #3 Cash Balance Plan 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 71

72 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) 72

73 Design #3 DC Plan 1 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 73

74 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 74

75 Design #3 DC Plan 2 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) 75

76 Design #3 DC Plan 2 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 76

77 Design #3 - Results Name Age PS Credit CB Credit Total 401(k) Deferrals Owner ,500 60,000 94,500 17,500 Owner , ,500 23,000 Owner , ,500 17,500 Owner , , ,500 23,000 Owner , , ,500 17,500 Owner , ,500 17,500 NHCE Staff Avg 45 23,867 7,810 31,677 11,924 77

78 Design #3 - Results Total cost for owners (including their deferrals) is $634,677 Owners are receiving a total allocation of $603,000 (or 95.01%) Staff cost = $31,677 (decrease of approx. $27,000 from Design #2) 78