Cash Balance for Beginners Kevin J. Donovan, CPA, EA, MSPA, Managing Member, Pinnacle Plan Design, LLC 1
Kevin Donovan, CPA, EA, MSPA, Managing Member, Pinnacle Plan Design, LLC Kevin is a shareholder in the accounting firm BeachFleischman PC, where he heads up the firm s pension subsidiary Pinnacle Plan Design, LLC. Kevin is a CPA and an Enrolled Actuary. He is a founding member of the ASPPA College of Pension Actuaries (ACOPA) and recently served as ACOPA's Vice President. In addition to being a member of NIPA, Kevin is a member of the American Society of Pension Professionals and Actuaries (ASPPA), as well as the American Institute of Certified Public Accountants (AICPA). Kevin is a frequent author and lecturer on qualified retirement plans. He has spoken at numerous conferences sponsored by ASPPA, NIPA, the AICPA, ACOPA, the Conference of Consulting Actuaries, and is a former instructor for PPD/Corbel.
Defined Contribution Plans IRC Section 414(i) "defined contribution plan" means a plan which provides for an individual account for each participant and for benefits based solely on the amount contributed to the participant's account, and any income, expenses, gains and losses, and any forfeitures of accounts of other participants which may be allocated to such participant's account Separate accounting maintained for each employee Each year credited with actual contribution and actual earnings Investment risk with employee 3
Defined Contribution Plans IRC Section 415 Maximum contribution on behalf of any individual is the lesser of 100% of compensation or Dollar limit ($53,000 for years ending in 2015) Additional catch-up contribution of $6,000 available if participant at least 50 years of age at calendar year-end and 401(k) plan maintained IRC Section 404 Maximum deduction 25% of total participant comp. 4
IRC Section 414(j) Defined Benefit Plans - General "defined benefit plan" means any plan which is not a defined contribution plan. Plan defines benefit to be paid at retirement age (or earlier separation from employment) Actuary determines amount to be deposited on annual basis to provide benefits called for under plan terms In addition to benefits, actuary takes into account expected rate of return and other factors (e.g., mortality and turnover) when determining required contribution Investment results serve to cause contributions to increase or decrease from year to year based on whether or not they exceed projected returns Investment risk with employer 5
Defined Benefit Plans - General IRC Section 415 Maximum benefit payable to any individual lesser of 100% of average compensation Reduced for years of service less than 10 Dollar limit ($210,000 for years ending in 2015) Reduced for years of participation less than 10 Reduced if commenced before age 62 Increased if commenced post age 65 Payable as straight life annuity (SLA) Adjusted if paid other than as SLA 6
Defined Benefit Plans - General Why a Defined Benefit Plan (vs a DC plan)? Provides larger (additional) limits than DC plan Sample DB contributions: Age 40 $ 85,000 Age 45 110,000 Age 50 140,000 Age 55 180,000 Age 60 235,000 These amounts could be sustained for ~ 10 years Assumes adequate comp. to support maximum dollar benefit 7
Defined Benefit Plans - General IRC Section 404 Maximum greatest of Target Normal Cost (TNC) + Shortfall amortization TNC + Funding Target (FT) + Cushion - Assets Cushion generally 50% of FT TNC + FT Assets as if plan At - risk Generally this is amount needed to fully fund benefits Combined plan limits if DB and DC 25% of participant comp, ignoring first 6% to DC So 31% of comp if all participants in DC Or maximum DB plus 6% to DC Limits do not apply if DB plan subject to PBGC coverage 8
IRC Section 404 Defined Benefit Plans - General 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, 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) Funding terms covered later in outline 9
Defined Benefit Plans - General DB plans are PENSION plans Benefit must be definitely determinable Clients tend to want flexibility Must not sell cash balance or any DB plan as super PSP Make client understand they are making a commitment e.g., 3 5 years, subject to change due to business conditions 10
Defined Benefit Plans - General Benefit payment restrictions With limited exceptions, prior to PPA 2006, DB plans were restricted from making lump sum payments to top-25 HCEs if plan was 110% funded Treasury Regulation 1.401(a)(4)-5(b)(3) Post PPA, IRC 436 restricts benefit payments to all participants where plan funding level below 80% 50% lump sums allowed if funded between 60 and 80% Lump sums under $5,000 still allowed It is important that client be made aware of these rules when considering any type of DB plan 11
Defined Benefit Plans - Traditional In traditional DBP participant normally receives retirement benefit defined as some percentage of pay or some flat dollar amount, subject to limits of IRC 415(b) For example, plan may provide participant will receive retirement benefit of 2% of average pay for each year of service with employer - participant with 30 years of service and average pay of $50,000 would receive annual retirement benefit of $30,000 Alternatively, plan may provide each participant will receive a monthly retirement benefit $50 for each year of service with employer - participant with 30 years of service would receive a monthly benefit of $1,500 12
Cash Balance Plans What is a Cash Balance Plan? Plan where benefit defined as theoretical account balance (TAB) As opposed to periodic benefit payment TAB paper account only Plan assets not actually divided into individual accounts TAB credited with Contribution credits Interest (earnings) credits at rate defined in plan document DB plan as benefit not based on actual earnings 13
Cash Balance Plans Example Plan effective 1/1/14 Single participant doctor/owner 2014 Compensation $200,000 2015 Compensation $250,000 Contribution credit 50% of compensation $100,000 for 2014; $125,000 for 2015 Interest crediting rate 5% 14
Cash Balance Plans Example (cont) TAB Balance 1/1/14 $ - 2014 contribution credit 100,000 Balance 12/31/14 (1/1/15) 100,000 2015 interest credit (5% of $100K) 5,000 2015 contribution credit 125,000 TAB Balance 12/31/15 $230,000 Actual plan assets may or may not = TABs Difference between assets and balances = amount needed to fill Employee statement would look something like this very similar to a statement in their DC plan 15
Cash Balance Plans Why use a Cash Balance Plan (vs traditional DB)? Provides more meaningful (understandable) benefit to employee verses traditional DB plan Recall previous example statement looked like PSP statement Compare to statement from traditional DB plan where statement tells participant of monthly benefit payable sometime in future In professional groups more able to equalize benefits Or identify how much of plan belongs to each Avoid lump sum swings due to interest rate shifts Age neutral contributions for non-owners 16
Cash Balance Plans Measuring the benefit Cash balance plan still must provide annuity benefit To determine 415 benefit limit Also for discrimination testing Returning to previous example assume Interest crediting rate of 5% Actuarial equivalence factors for converting TAB to SLA Interest 5% / 2014 applicable mortality table Participant date of birth 12/31/1965 Normal retirement age (NRA) 62 Normal retirement date (NRD) 12/31/2027 17
Cash Balance Plans 12/31/14 TAB $100,000 Age 49; 13 years to NRA TAB projected to NRA $100,000 * (1.05 ^ 13) = $188,565 Annuity factor 156.321 Monthly annuity ( accrued benefit ) $188,565 / 156.321 = $1,206.27 As % of compensation $1,206.27 / 200,000 * 12 = 7.24% 18
Cash Balance Plans 12/31/15 TAB $230,000; Age 50; 12 years to NRA TAB projected to NRA $230,000 * (1.05 ^ 12) = $413,047 Annuity factor 156.321 Monthly annuity $413,047 / 156.321 = $2,642.30 Increase $2,642.30 - $1,206.27 = $1,436.03 As % compensation $1,436.03 / 250,000 * 12 = 6.89% 19
Cash Balance Plans - Funding Cash balance plans funded by projecting forward to NRA using interest crediting rate and discounting back using three segment rates published monthly by IRS S1, S2, S3 are segment rates for applicable month S1 - Payments expected to be made within 5 years S2 - Payments expected to be made during following 15 years S3 - Payments expected to be made thereafter Applicable month is month that includes valuation date unless otherwise elected (below) May elect to use one of 4 months preceding val date e.g., for 12/31/2014 valuation cold use August, September, October, November or December 2014 rates 20
Cash Balance Plans - Funding Rates for August, 2014 (after recent law change) S1 4.99%; S2 6.32%; S3 6.99% Assume prior example (crediting rate < segment rate): Theoretical contribution of $100,000 Employee 13 years from retirement therefore use S2 for discounting Interest crediting rate 5% Future value at 5% = $188,565 Present value at 6.32% = $85,009 This represents Target Normal Cost (TNC) and in year one would be actual funding requirement (plus interest if made after val date) 21
Cash Balance Plans - Deductions Rates for August, 2014 for deduction purposes S1 1.15%; S2 4.06%; S3 5.14% Assume prior example (crediting rate < segment rate): Theoretical contribution of $100,000 Employee 13 years from retirement therefore use S2 for discounting Interest crediting rate 5% Future value at 5% = $188,565 Present value at 4.06% = $112,401 This represents Target Normal Cost (TNC) for deduction purposes such that full $100,000 can be contributed/deducted The maximum deduction in year one would be $112,401 22
Cash Balance Plans - Testing CB Plan must be non-discriminatory Use general test (Treas. Reg. 1.401(a)(4)) Test passed if, at each relative level of benefits, percentage coverage by non-hces is sufficiently high compared to HCE coverage E.g., Consider all participants with benefit accrual rates of 5% of pay or higher Need sufficient number of non-hces at 5%+ for each HCE at 5%+ 23
Cash Balance Plans - Testing Assumptions: Testing compensation = plan compensation Testing age ( TA ) = NRA of 62 Normal accrual rate determined by dividing increase in accrued benefit by testing compensation - Treas. Reg. 1.401(a)(4)-3(d) If NRA not same as Testing age: Normalize from NRA to TA Possible benefits, right & features issue if in-service distributions not equal in availability (if testing with DC) 24
Cash Balance Plans - Testing Add employee age 29; comp $40,000; comp. credit 19% 12/31/14 Theoretical contribution $7,600 Age 29; 33 years to NRA Projected to NRA $7,600 * (1.05 ^ 33) = $38,024 Annuity factor 156.321 Monthly annuity $ 38,024 / 156.321 = $243.24 As % of compensation $ 243.24 / 40,000 * 12 = 7.30% Recall owner at 7.24% 25
Cash Balance Plans - Testing Cheaper to provide employee dollars in DC plan Add employee age 29; comp $40,000; PS 7.5% 12/31/14 PS allocation $3,000 Age 29; 33 years to NRA Projected to NRA $3,000 * (1.085 ^ 33) = $44,290 Annuity factor 101.718 (testing factors; 8.5%, 71 GAM male) Monthly annuity $ 44,290 / 101.718 = $435.42 As % of compensation $ 435.42 / 40,000 * 12 = 13.06% 26
Cash Balance Plans - Testing DB plan must also pass minimum participation rules of IRC 401(a)(26) standing on its own Does not apply to DC plans Must provide meaningful benefits to lesser of 50 employees or 40 percent of non-excludable employees (regardless of whether benefiting participants are HCEs or NHCEs) [Treasury Regulation 1.401(a)(26)-3(c)(1)] If only 2 non-excludable employees must provide to both HCE / non-hce status irrelevant IRS has stated then accrual of.5% is meaningful 27
Cash Balance Plans - Testing In above Example, if HCE and NHCE are only nonexcludable employees, NHCE must be covered by CB Plan at meaningful level If other non-excludables in Example, cover lesser of 40% or 50 employees at meaningful level Where Testing Age and NRA are not same, 0.5% must be measured at Plan s NRA Use accrued benefit for this purpose, not the accrued benefit normalized to testing age 28
Cash Balance Plans - Testing Employee age 29; comp $40,000; comp. credit 1.5% 12/31/14 Theoretical contribution credit $600 (40,000 * 1.5%) 33 years to NRA Projected to NRA $600 * (1.05 ^ 33) = $3,002 Annuity factor 156.321 Monthly annuity $ 3,002 / 156.321 = $19.20 As % of compensation $ 19.20 / 40,000 * 12 =.58% Meaningful for purposes of IRC 401(a)(26) 29
Cash Balance Plans - Testing Give doctor $11,400 PS = 6% of total comp. ($200,000 + $40,000) less PS to ee Age 49; 13 years to NRA Projected to NRA $11,400 * (1.085 ^ 13) = $32,922 Annuity factor 101.718 (see above) Monthly annuity $ 32,922 / 101.718 = $323.66 As % of compensation $ 323.66 / 200,000 * 12 = 1.94% Add DB of 7.24% for aggregate normal accrual rate of 9.18% Employee 13.06% (PS) +.57% (DB) = 13.63% 30
Cash Balance Plans - Testing Most Valuable Accrual Rate (MVAR) Determined by calculating normalized QJSA associated with accrued benefit potentially payable in current and each future plan year and selecting largest Treas. Reg. 1.401(a)(4)-3(d)(1)(ii) 31
Cash Balance Plans - Testing Most Valuable Accrual Rate (MVAR) Convert current pay credit to QJSA payable at current age $100,000 / 202.312 = 494.29 i.e., if this was full balance and owner left and elected J&S this would be the amount payable Normalized by converting to actuarially equivalent straight life annuity commencing at Testing Age 32
Cash Balance Plans - Testing Most Valuable Accrual Rate (MVAR) J&S APR age 49 testing table / rates = 130.164 Testing rate = 8.5% Years to testing age = 13 (62 49) SLA APR age 62 testing table / rates = 101.718 MVAR = 10.96% 494.29 * 12 * 130.164 * (1.085^13) / 101.718 / 200,000 33
Cash Balance Plans - Testing MVAR No separate MVAR for profit sharing contributions Instead, aggregate MVAR is sum of EBAR attributable to profit sharing contributions and MVAR from cash balance plan [Treas. Reg. 1.401(a)(4)-9(b)(2)(ii)(B)] MVAR calculated as follows: MVAR from Cash Balance plan 10.96% EBAR from PS plan 1.96% Aggregate most valuable accrual rate 12.92% Employee will surely be greater as normal rate = 13.63% 34
Cash Balance Plans - Testing Combined plan Gateway Treas. Reg. 1.401(a)(4)-9(b)(2)(v) To pass nondiscrimination in amounts test, must also satisfy one of following : Primarily defined benefit in character Broadly available separate plans, or Minimum allocation gateway Focus on minimum allocation gateway 35
Cash Balance Plans - Testing Combined plan Gateway Minimum aggregate allocation gateway passed if each NHCE has an aggregate normal allocation rate (ANAR) as follows: If the highest ANAR of any HCE does not exceed 25% of compensation, each NHCE must have ANAR of lesser of: one third (1/3rd) of the ANAR of the HCE with the highest such rate, or 5% 36
Cash Balance Plans - Testing Combined plan Gateway If highest HCE ANAR > 25% of compensation, the ANAR for each non-hce must be at least 5% increased by 1% for each 5% (or portion thereof) by which the HCE rate exceeds 25% E.g. if highest HCE rate exceeds 25% but not 30%, non- HCE minimum is 6% E.g., if highest HCE rate exceeds 30% but not 35%, non- HCE minimum is 7% Treas. Reg. 1.401(a)(4)-9(b)(2)(v)(D)(1) 37
Cash Balance Plans - Testing Combined plan Gateway Deemed to satisfy the gateway if ANAR for each non-hce is at least 7.5% of 415(c)(3) compensation Compensation may be over participation E.g., if highest HCE rate exceeds 30% but not 35%, non-hce minimum is 7% Treas. Reg. 1.401(a)(4)-9(b)(2)(v)(D)(2) 38
Cash Balance Plans - Testing Combined plan Gateway A participant s equivalent normal allocation rate is the actuarial present value of the increase in the participant s accrued benefit under the employer s defined benefit plan(s), expressed as a percentage of plan year compensation The actuarial present value of the increase in the participant s accrued benefit is determined using a standard interest rate and a standard mortality table Treas. Reg. 1.401(a)(4)-8(c)(2)(ii) 39
Cash Balance Plans - Testing HCE equivalent normal allocation rate for CB Plan: Increase in accrued benefit: $1,206.27 Age 62 APR (71 GAM 8.5%) 101.718 Value of benefit at testing age $122,699 PV age (49) at 8.5% $42,487 Testing comp. $200,000 Equivalent normal allocation rate 21.24% HCE Profit-sharing allocation rate: $11,400 / $200,000: 5.7% 40
Cash Balance Plans - Testing ANAR for HCE: HCE Profit-sharing allocation rate 5.70% Equivalent normal alloc rate 21.24% ANAR 26.94% Between 25% and 30%, so gateway = 6% Each NHCE s ANAR must be at least 6% Since NHCE got this + in DC gateway passed 41
Cash Balance Plans Stable Lump Sums Cash balance avoids interest rate volatility inherent in traditional DB plans Compare above cash balance v. monthly accrued benefit of $1,206.27 in traditional plan (ignore 2015 accruals) Lump sum in cash balance at 12/31/15 $100,000 * 1.05 = $105,000 (this is a known) Traditional DB plan, assume at 12/31/14 all relevant interest rates are 5%, same table as above, lump sum therefore $100,000 Assume interest rates go to 4% at 12/31/15 Lump sum now $1,206.27 * 172.117 * (1.04 ^ -12) = $129,678 42
Cash Balance Plans Age Neutrality Cash balance avoids spike in costs for older non-owners Assume second employee with same data except age 59 instead of 29 Goal to offer similar benefits to employees Recall 1.5% cont. credit provided.57% benefit for 29 year old It would take 5.48% to provide.5% benefit for 59 year old 5.63% * $40,000 = $2,252 (contribution credit) $2,252 * (1.05 ^ 3) = $2,607 (projected to NRA) $2,607 / 156.321 = $16.68 (monthly benefit at NRA) $16.68 / $40,000 * 12 =.5% (benefit as % of compensation) With cash balance give both employees 1.5% cont. credit Recall only 40% need.5% so 2 of 3 would be there 43
Combined Plan limits - Examples - Census Compensation Age HCE 1 Dr./owner $ 265,000 57 HCE 2 non owner Dr. 265,000 41 NHCE 1 15,000 27 NHCE 2 30,000 43 NHCE 3 30,000 60 NHCE 4 30,000 60 NHCE 5 25,000 41 NHCE 6 25,000 25 Total $ 685,000 44
Combined Plan limits - Example 1 DC over 6% DC plan: 3% non-elective safe harbor 401(k) + profit sharing as follows: Maximize Owner No additional to non-owner HCE 3.5% to NHCEs DB plan: Cash balance plan with contribution credits as follows: Owner 58.5% of compensation not to exceed $155,000 (exclude non-owner HCE) NHCEs - 5% of compensation not to exceed $720 Assume fund CB credits 45
Combined Plan limits - Example 1 DC over 6% PS/SH Cash Balance Total Employer 401(k) Total HCE 1 $ 35,000 $ 155,000 $ 190,000 $ 24,000 $ 214,000 HCE 2 7,950-0- 7,950 18,000 25,950 NHCE 1 975 720 1,695 1,695 NHCE 2 1,950 720 2,670 2,670 NHCE 3 1,950 720 2,670 2,670 NHCE 4 1,950 720 2,670 2,670 NHCE 5 1,625 720 2,345 2,345 NHCE 6 1,625 720 2,345 2,345 Total $ 53,025 $159,320 $ 212,345 $ 42,000 $ 254,345 46
Combined Plan limits - Example 1 DC over 6% Total employer contributions 212,345 31% limit ($685,000 * 31%) 212,350 47
Combined Plan limits - Example 2 DC Under 6% 3% safe harbor 401(k) excludes HCEs i.e. Drs do not get 3% SH + profit sharing as follows: $23,075 to owner 3% to non-owner HCE 3.5% to NHCEs DB plan: Cash balance plan with contribution credits as follows: Owner $205,000 (exclude non-owner HCE) NHCEs - 5% of compensation not to exceed $720 48
Combined Plan limits - Example 2 DC Under 6% PS/SH Cash Balance Total Employer 401(k) Total HCE 1 $ 23,075 $205,000 $ 228,075 $ 22,000 $ 252,075 HCE 2 7,950-0- 7,950 18,000 25,950 NHCE 1 975 720 1,695 1,695 NHCE 2 1,950 720 2,670 2,670 NHCE 3 1,950 720 2,670 2,670 NHCE 4 1,950 720 2,670 2,670 NHCE 5 1,625 720 2,345 2,345 NHCE 6 1,625 720 2,345 2,345 Total $ 41,100 $209,320 $ 250,420 $ 42,000 $ 292,420 49
Combined Plan limits - Example 2 DC Under 6% Employer DC under 6% of comp: 6% * $685,000 = $41,100 Employer DC = $41,100 25%/31% limit therefore not applicable Important that HCEs benefited in DC to use comp. In applying 6% limit 50
Combined Plan limits Ex. 3 - PBGC Covered Plan 3% safe harbor 401(k) excludes HCEs i.e. Drs do not get 3% SH + profit sharing as follows: Max owner 3% to non-owner HCE 3.5% to NHCEs DB plan: Cash balance plan with contribution credits as follows: Owner $205,000 (exclude non-owner HCE) NHCEs - 5% of compensation not to exceed $720 51
Combined Plan limits Ex. 3 - PBGC Covered Plan PS/SH Cash Balance Total Employer 401(k) Total HCE 1 $ 35,000 $205,000 $ 240,000 $ 24,000 $ 264,000 HCE 2 7,950-0- 7,950 18,000 25,950 NHCE 1 975 720 1,695 1,695 NHCE 2 1,950 720 2,670 2,670 NHCE 3 1,950 720 2,670 2,670 NHCE 4 1,950 720 2,670 2,670 NHCE 5 1,625 720 2,345 2,345 NHCE 6 1,625 720 2,345 2,345 Total $ 53,025 $209,320 $ 262,345 $ 42,000 $ 304,345 52
Combined Plan limits Ex. 3 - PBGC Covered Plan Total for Owner $241,500 Cost for employees Non-owner HCE 32,500 Other employees 23,375 Total employer contributions $275,375 Exceeds 31% of compensation But PBGC plan so combined plan limit N/A Assumes not Dr/Professional as under 25 active participants ERISA 4021(b)(13) 53