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Mike Preston

Currently with a solo-401k; does it make sense to add cash balance plan? Take two

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We recently had a discussion about when it is logical to suggest a cash balance plan instead of a traditional DB for a 1 person plan.  I presented two, off the top of my head, reasons why I thought it not in the client's best interests to go the cash balance route: the fact that cash balance plans have been individually designed plans (and hence both more expensive to maintain and providing less protection, on audit, than a volume submitter plan) and the fact that in the event of death the strong recommendation of document providers is to either submit a 5310 or (eventually) amend and restate under a volume submitter plan.  In any event, both of my objections will soon evaporate when CB Volume Submitter plans become available.

But I got to thinking and there are other reasons.  One of the arguments put forward in favor of the CB plan is that the client understands the CB plan better because, in general, the contribution equals or is close to the defined CB allocation.  In technical terms, each year's contribution consists largely of target normal cost and there is precious little based on the funding target.  But that pattern is notoriously unforgiving.  In fact, a traditional formula allows the consultant to design a funding pattern for the first few years of a plan that is based on the cushion under 404.  This subsequently allows for tremendous flexibility in funding in later years, which means no worries of minimum funding violations, while at the same time allowing for substantial maximum deductible contributions.  Can this pattern come to be in a CB plan?  Of course it can (although it is much more difficult to do so if the client has been told that focusing on the current year's formula means something).  But it obliterates the argument that the CB plan is more understandable because the annual contribution is closely related to the target normal cost.

As Larry so accurately pointed out, while a client might understand some of the concepts that impact a plan, unless the client is a pension professional, it falls on us to actually understand those concepts and to implement them in a way that allows the client to meet their goals, both short term and long term.

Another concept might help to explain my attraction to the traditional plan: the CB plan essentially overlays the CB requirements over the traditional plan's ruleset.  Stated another way, all the rules of the traditional plan (with the exception of 417(e) and a faster vesting schedule that has no impact on one person plans) remain in effect when the plan is a CB plan (415 limits, minimum funding, 404 funding, restrictions on distributions if the plan is not adequately funded, accrual rules under 411, etc.).  On the other hand, none of the CB rules are in effect when the plan is a traditional DB plan.  So, why would you want to worry about 2 sets of rules when you don't have to?

Here is an example.  When CB plans were in their infancy, the IRS allowed interest crediting rates that were eventually determined impermissible.  The IRS gave us leeway on how to transition from what ended up being described as impermissible rates to the newly defined permissible rates.  Why subject a plan sponsor to that kind of issue if you don't have to?     Think it can't happen again?  Yes, it can.  Of course, that same thing can happen to any plan design, but it is much less likely to come up with a traditional design than a cash balance design.  Again: the plan is subject to two rulesets (traditional AND CB) when it just doesn't need to be.

And yet, there is more.  A cash balance plan has to do additional work to convert hypothetical account balances to J&S annuity values when preparing relative value disclosures.  Those J&S annuity values, when based on traditional formulas, either automatically pop out (if they are expressed in the normal form) or are dead simple to convert. 

I'm pretty sure that this missive won't change anybody's opinion about the type of plan that's best for a one person plan.  But for me it is simple. If a traditional plan can be designed to meet the needs of a client then suggesting a CB plan unnecessarily subjects the client to rules that they wouldn't normally have to worry about and, at some level, exposes them to additional costs.

Only if there are offsetting advantages would it make sense to advocate for a CB plan.

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Mike, just out of curiosity - if you think of all the DB plans you have worked on in just, say, the last 10 years - what percentage has been cash balance? I could be wrong, but I suspect it is a low number.

As I start reading your post here, the very first point you mention - that cash balance plans have been individually designed plans and hence more expensive to maintain - is something I disagree with. That right there is something that's going to vary from firm to firm and client to client. For my clients, they are going to pay the same fees (both setup and annual) whether it's a cash balance or trad'l DB plan. At least it's been this way for the last 4+ years. I understand some firms don't do this though.

You have some points, but I do think your viewpoint is skewed based on your own experiences, as is mine.

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You didn't read my first point thoroughly, huh?  Look, I get it, your clients enjoy a constant relationship between total income and desired contribution.  Mine don't.  Income sometimes goes down (sometimes all the way to zero after consideration of the deductible DB contribution). And then there are years where exactly the opposite takes place.  You like a static relationship between compensation and contribution.  If that keeps your clients happy, more power to you.

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I was talking about fees (again, in reference to your first point mentioned: "more expensive to maintain" on account of being individually designed).

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Just to be clear - I understand the individually designed stuff is basically no longer an issue. I'm only pointing this out because it's an example of something you're basically stating has been a fact, when in reality it's not. Perhaps it (i.e., a CB plan having more fees than a trad'l DB plan) has been true in your specific experiences, but it's not a truth for everyone. I was just using that as an example of how your experiences (which I assume are very heavily weighted towards trad'l DB instead of CB) are skewing your perspective. I could go on with other things mentioned, but there's really no need to. Trad'l DB is in your blood. It's fine. I'm a CB guy.

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You didn't read my first point thoroughly, huh?

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We should not be a "Trad'l DB guy" or a "CB guy". We should do what's best for a client. Just let it go Mike :)

 

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From my perspective, the current pension valuation tools solve all of the problems that Mike addressed.  The client who does not understand present value math will find the CB plan much more to his liking, while the convert from public plan employment will understand the traditional DB formulas more easily, unless they offer lump sum benefits.

I find the 417(e) rules definitely favor CB.

Edited by SoCalActuary
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