Looking for clarification of permitted aggregation of DC and DB plan along with the "special gateway test"

[Guest smhjr]

It seems this topic is being forced upon me more often and so I have been trying to research as best I can. But with anything that is not within my comfort zone, even if I think I have it figured out it makes me feel better to get independent confirmation.

The facts are that we have an S corp with Owner #1 (100% owner) is 70 and taking a salary of $150,000 and the amount seems to be flexible. Owner #2 is the spouse age 76 and he is collecting a nominal salary of $15,000 a year. This is also flexible, but historically has been low or none at all. There are 2 employees that make between 40k-60k that are in their late 40s to early 50s.

Of course the client wants to sock away as much as possible for themselves and as little as possible for the two employees. For the sake of argument let's assume both owners will work at least another 5 years.

In Sal Tripodi's ERISA outline book he gives an example of a DB/DC combo design in which the DB plan does not cover any NHCs. Since the plan's can not pass discrimination tests on their own, the plans are permissively aggregated for testing purposes. 401(a)(26) is passed because 50% of the employees are covered in the DB plan.

-------------------------------------------

Ok I think I am ok with everything up to this point, but I am getting a little hazy on the testing of the benefits to be certain that the benefits provided are not discriminatory.

--------------------------------------------

Tres.Reg 1.401(a)(4)-9(b)(2)(v)(D) deals with the special gateway test for DB/DC plans. The example in the ERISA Outline book explains how to look at the testing but assumes that all employees are covered in both plans. It basically takes the normal allocation rate for the HCE in the DC plan, adds it to the equivalent allocation rate in the DB plan and then compares it to the NHC average to be certain we are passing 401(a)(4) rate group testing applying the gateway rules (NHC allocation rate must be 1/3 the HCE allocation rate if the HCE allocation rate is less than 15% or the NHC rate must be 5% if the HCE allocation rate is between 15% and 25% and provides for 1% increases if the HCE allocation is higher). There is also mention that 7.5% to the NHC is a safe harbor amount even if the HCE allocation is over 40%.

In my specific case, the DB plan is a 75% formula reduced by 1/25 for each year of participation less than 25 years. The DC plan is run at 7.5% of pay.

When I run the discrimination testing in Datair, there are 2 tests that give me values for the 401(a)(4) test. The first is called the annual test. The most valuable rate for owner #1 and owner #2 is 3.0 (1/25*.75). The value for NHC#1 is 4.30 and for NHC#2 is 3.28.

The other test which I get values for is called Equivalent Allocation. The values for Owner#1 is 21.47, Owner#2 is 23.91, NHC#1 is 7.50, and NHC#2 is 7.50.

Based on my superior sleuth like abilities (ha) I feel comfortable saying that the values for the NHC on the first test is the same as testing the contribution based on benefits. The 4.30 and the 3.28 are EBARs. On the second test, the 7.5% is obviously just the 7.5% allocation rate that they received.

The testing shows that the first test (annual) passes because both NHC rates are higher than both HCE rates. THe second test fails because of course the values are reversed.

So the big question is, can I rely on the annual test to pass the 401(a)(4) testing? Or do I need to increase the NHC allocation in the DC plan to 23.91% so that the equivalent allocation test is passed?

My gut is telling me that we are passing the test because the annual test is passing, and perhaps I can lower the DC allocation lower than 7.5%. Although I am not overly concerned with saving a few hundred dollars in employee costs.

Thanks for reading my novel here and thanks even more if you have input.

[SoCalActuary]

Looks like you need someone to check your test. Got a good local actuary?

[Guest Partly Cloudy]

I also use Datair. Since your plans are not primarily DB in nature, nor are there broadly available separate plans, the plans will need to satisfy the gateway requirement. The equivalent allocation rate w/o PD column will give you the number you need to look at for the highest HCE in order to determine the gateway % requirement. In your example, the gateway requirement is 5% (23.91% is between 15% and 25% so the gateway requirement = 5%). Keep in mind that you can average the NHCE rates to pass the gateway requirement. Apparently your testing assumptions are the same as your actuarial equivalence definition since the Most Valuable EBAR equals the Normal EBAR. Given your facts, the combined plan passes the ratio percentage test for 410(b) purposes and passes 401(a)(4) rate group testing with each rate group's passing % greater than 70% (so the Average Benefits Test is not needed). You only have to pass rate group testing on one of the three methods, annual accrual, accrued to date, or equivalent allocation.

Now, given the plan sponsor's objectives, I would run it using a lower DC contribution rather than 7.5% and see what happens. 5% may not allow the plan to pass a4 testing but 5.5% probably would.

You can feel free to email me if you like.

[AndyH]

Hey smhjr, if all of your allocation rates are below 25%, it seems to me that you could achieve similar allocations in one cross tested PS plan. The only 2 plan advantage that I can think of in your situation would be the use of the low 417(e) rates, but that needs to be in your MVAR test anyway.

Am I missing something? I see limited use for DB/DC combos unless (1)the desired deduction is over 25% of pay, (2) the DB accrual is large (over the DC limit) for the targeted HCE(s), or (3) you are shafting some HCEs. None of these apply here.

[Guest smhjr]

I am unsure (aka clueless) of the mathematics that Datair is doing to come up with the 23.71 as an equivalent allocation, but the contributions for the two owners is definitely over 25% of pay if you are just looking at it as X contribution divided by Y compensation. Playing around with some of the assumptions leads me to believe that the equivalent allocation test is based off of the monthly benefit received by the individual and not the actual cost of the benefit.

I wouldn't mind learning how the math is done, but I have a feeling by the time I figured it out I might as well go take the test and become an actuary. Although, once upon a time I had the formula to calculate EBARs for the new comparability profit sharing plans but regretably I have misplaced it. Maybe its just the opposite equation

[AndyH]

Well, in simple terms, in the situation you describe you seem to have two results, one on a benefits basis and one on a contributions basis. And a 23% allocation rate on a contributions basis means that the value of the accrual is 23% of pay. Now that is calculated using a rate between 7.50% and 8.50% (whatever your testing assumption is), which will amost certainly be higher than the rate used for funding, because the rate used for funding will take into account the rules under 417(e) which will compute the present value somewhere around 5%. But that same reality must be factored into the Most Valuable Accrual Rate part of the general test.

Suffice it to say that your client should be presented with a one-PS plan option as an alternative to a DB/DC combo if you wish to properly advise them. IMHO

[SoCalActuary]

By achieving a contribution in excess of 25% for the owner, you still have not given the major reason for the DB. You can exceed $41,000 of benefit value in a DB, but not a DC. For testing purposes, the gateway test thinks you have less than 25% cost, since the benefit is converted to cost using a high interest rate. The DB/DC combo still gives a better result than a single cross-tested DC.

Don't forget that you can allocate more than 25% to an individual in a DC, so long as the combined contribution of all participants is not above the 25% deduction limit. However, again, you cannot exceed the 415 limit. Meanwhile, in a DB plan, the maximum benefit lump sum value is about $190,000 at age 65.

However, in the fact pattern you described, you can cut your fees down (a valuable priority to the client) by just having the DC plan. With total pay of:

1 150,000

2 15,000

3 60,000

4 50,000

total 275,000 x 25% = 68,750 deductible amount

Does the client want to spend that much? If not, then go DC only.

[Guest smhjr]

The client in particular is old and fairly set in his ways. Since we are talking about people in their 70s they also really aren't too interested in trying to beat the market either. They are the type of people that are invested nearly 100% in money market and other guaranteed investments because they don't want to risk losing money at this stage in life.

We are looking to present a profit sharing plan, and the DB/DC combo plan. The DB plan might be a typical design, but we are looking at an annuity only plan. The annuity only plan should alleviate their concerns about investing in the market as well as keep their plan costs relatively low.

Covering the other 2 employees in the annuity only plan though is pretty expensive and that is how this whole process started. I'm not overly thrilled about an annuity only plan, but they are pretty adamant about not wanting to put money at risk.

This client is one of those situations that came along at a perfect time. I'm not too busy except filing extensions so I am using this time to look at a lot of different scenarios. The thrust of the post was to try and figure out the correct way to be testing this scenario, and I think I have it figured out now with everyone's help. We very well may end up with a profit sharing plan only, but it's been a learning experience for me now so I don't mind all the time I have spent on it now.

Thanks to those that gave me some insight.

[AndyH]

[Well, one or two more thoughts before you go.

There is absolutely nothing cheaper about an "annuity only plan"! Are you going to maintain the plan until both die and invest the money in 1% money market rates? Then you will have continuing actuarial fees and escalating contribution levels.

Or are you going to purchase annuities? Have you considered the cost of annuities? I think that you will find that they are not much, if any, cheaper than paying lump sums. Time to reconsider.

And, Socal, I'm interested in your comment that "The DB/DC combo still gives a better result than a single cross-tested DC." How so with pay of $150,000?

[Guest smhjr]

Honestly Andy I don't know. I don't have a securities license or an insurance license or any other vested interest in what the client ultimately invests in.

What I do know is that the client is old. He is very private about his financial affairs. They wear funny clothes that seem to have been purchased 25 years ago, the same kind my grandparents wear around the house (not trying to be sarcastic just giving perspective into who they are and my thoughts regarding it). I do get the feeling though that they have enough money that they have no reason to worry, but yet they don't outwardly seem to spend any of it. My guess is either that they are trying to accumulate as much as they can to pass to their heirs, or they are afraid they will out live their money so they save as much as possible. He seems to be ultra conservaitve with his investments. I do know that he has some certificates of deposit, some money market investments, and some annuity investments already. What I don't know is if they have recently moved their money into these types of guaranteed investments or if it has been this way for a long time. I suppose based on their age it is the right time in the lifecycle to have your money in places where you can't lose.

If they go with a DB plan and invest in money market they would have increasing costs each year as well as a schedule B requirement which equals actuary costs (like you said). If they only invest in money market, it is very likely that the admin fees for two plans and actuary fees will result in a negative rate of return.

If they go with the profit sharing plan then they can invest in whatever they want and their contribution is flexible but limited somewhat. The admin fees are cheap.

If they go with the annuity only plan they can get a slightly higher interest rate than the money market and have relatively stable contributions. The admin fees are higher because again there are two plans, but no actuary fees.

I just have a feeling that he will like knowing what his contirbution will be each year. It may even have the possibility of dropping slightly if he earns more interest than the guarantee. I also wonder why they don't have a retirement plan, and maybe it's a possiblity that no one has presented something that fits for him. Perhaps the annuity only plan is the right fit. That's is why I am looking at it as an option.

Now I don't know if they feel the risk of dying soon would deter them from purchasing more annuity investments or not. Heck they might have a family history of long prosperous lives and are looking to beat the system with annuities I really can't say. I do know that there are some 2% and 3% guaranteed annuities out in the market place, but no, I haven't done a financial model on the merits of either money market, or annuities, or mutual fund investments. Quite honestly I don't think it's my place to do it, and I'm not qualified to do it anyways. I'm just trying to offer the client options that they will be comfortable with. I'm sure their financial advisor has fancier programs than me when dealing with those issues.

As to the cost of purchasing an annuity compared to just paying the lump sums.....that's a whole other question. If we fund the plan, pay a lump sum, and they turn around and invest the distribution into an annuity, what have we just accomplished?

On the flip side if we invest the plan in money market for 5 years and they retire, terminate the plan, and elect an annuity we need to go purchase an annuity. This will likely cost more than the plan has in assets which will cause more problems. If I remember correctly this results in an deduction amortization period that may never be able to be taken advantage of.

Lastly if we fund at the guaranteed annuity rate, they retire in 5 years, terminate the plan, and elect a lump sum we also have other issues. As long as we assume the annuity only plan is subject to 417(e) rates for lump sum distributions we are should have assets left over in the plan after the lump sums are paid. Now we have a reversion.

I also think it just as likely that the client feels there is not a real enough benefit for him at this stage in his life with his investment goals and the fees that are involved to adopt a retirement plan at all.

Thanks for the discussion it makes me think which is usually a good thing Feel free to add more to it too, I am sure there are things I am missing. A lof of this is new to me or stuff I haven't thought about in a long time.

[AndyH]

Now, this is getting even weirder. I guess I misunderstood.

Are you saying these two schmos are going to set up a 412(i) plan in their 70s???!!!

And the reasoning is that the rates of return are better than they can get under their pillows? Maybe it's me, but this is getting hilarious.

"I'm sure their financial advisor has fancier programs than me when dealing with those issues".

And I'll bet that he has a yacht and a couple of mansions too. And he'll soon be able to afford a Bentley.

Boy was I wrong. A general tested 412(i) combo looks like a great fit. Perhaps a QSERP and a Top Hat plan added in might make these people feel modern enough to buy new clothes!

Just don't forget the minimum distributions.

[Guest smhjr]

Hmm I don't think it's like that. The financial advisor is an old guy too, seems to be a friend of theirs. I don't know if he has ever even heard of a fully insured plan. Are you implying that people make enough to afford a Bentley from selling some annuities? I wouldn't think the commission wouldn't be any more than selling a mutual fund.

My thought process went like this:

I designed a profit sharing only plan. Then looked at a defiend benefit plan with all the employees in the the DB. Looked at a fully insured annuity only DB plan thinking that the client invests primarily in annuity type investments anyways. Wanted to look at permissively aggregating a DB and DC plan to see what that would like like and that's what lead to my orignial post.

I'm not sure how my potential clients and the financial advisor and went from people looking at different retirement plan options into unfashionable Bentley driving Schmos. Maybe I'm just the schmo for considering that a fully insured annuity only plan might fit for the client. I don't see how any of the facts have changed from a client that was going to invest his DB plan assets in annuity investments (which might be a dumb idea) to a client that would invest those same annuity assets in a fully insured plan to eliminate the schedule B and fees that go with it.

I thought we were having a real discussion. I wish we were, because I can't think of why this particular client and a fully insured plan has no merit to even look at. Granted I don't have any hands on experience with a fully insured plan just stuff I have read, but how hard can they be?

[AndyH]

Don't take my comment too seriously. I was just having fun with it; I found your descriptions of these people to be amusing. I'm not one to discuss rationally the merits of 412(i) plans because I am totally opposed to them, especially in a situation where the contributions paid might never be recovered from the commissions.

Leaving the 412(i) issue aside for a moment, you were considering the right approaches. But I'm not sure you realize that a DB plan that is invested in money market investments is a recipe for disaster. Because an actuary cannot assume a 2% investment return, there will be huge losses resulting which will rapidly escalate the required contribution, and that is not a good idea for unsophisticated financial people in their 70s.

If you put the money in annuities or life insurance, there may be commissions and surrender charges which may be designed to outlive the life of the plan, so I would strongly advise against that. Then again, I readily admit my bias. But I've seen lots of people get ripped off.

All this being said, there is nothing wrong with presenting the DB combo approach but I think the negatives far outweigh the positives in these circumstances, and if you have any consideration for the client be very careful about what the client is told about a 412(i) approach, in particular the "exit strategy". The best way to look at that is to compare how much goes in to how much might come out.

[Guest smhjr]

Alright, whew, I didn't think I was that off base with my logic. In this scenario there isn't any exit option because there isn't anything to exit. I too have read some stuff about exiting insurance policies from the plan, but I figured that was all gone with the IRS position on that stuff. Didn't that come out within the past year or something? I was just looking at it as if they funded it 100% with annuity it might fit (who would buy insurance at that age anyways it would cost a fortune). I should also note that in my first example I looked at their retirmenet ages and not their actual ages when I mad ethe post. They are 65 and 71, not 70 and 76. That really doesn't change anytihng though excpet their life expectancy post retirement.

I was under the impression that insurance companies make very little money on annuities if the individual lives their entire life expectancy. Then it's just a toss up as to who dies too early or lives too long. If you live longer than you are expected to then you are ahead.

I guess you can argue about whether or not insurance companies offer competitive products, but last I checked there are tons of 401(k) plan issued by the likes of Lincoln and Nationwide. Often times other products have 12b-1 fees being paid to someone somewhere that are mostly hidden costs.

Gosh I am getting way off base, and I don't even particularly like insurance products but now I sound like I am defending them. I swear I don't even own any life insurance on myself. Hopefully I didn't just jynx myself.

[Guest tonymascia1]

This thread has been very interesting.

I always learn something useful regarding DB/DC combos, permitted aggregation, and gateway tests. When the conversation changed to 412(i) plans --- as I'm sure it has in boatloads of other threads --- the "fear and loathing" of financial salespeople reared its ugly head.

I've specialized in marketing owner-favored qualified plans since the mid-80s, and happen to AGREE with those you who think most of us who market 412(i) plans (rather than finding the right plan to solve a client's problem) are slugs. As a tax-reduction, rapid accumulation, and conservative fixed-return vehicle, 412(i) plans do have their place. As a rule, though, properly-designed DB plans and/or DB/DC carve-outs have better economics, and work in more situations. But I'm preaching to the choir here, aren't I?

Thanks for keeping us honest.

[AndyH]

Tony, forgetting the 412(i) phrase for a moment, is is appropriate to sell annuities of any type to people in their 70's?

Maybe it is. Admittedly, I'm a skeptic.

If so, please educate me.

[Guest tonymascia1]

Hi Andy,

There are RARE instances where deferred annuities (low surrender charges and short surrender periods) can be better than other fixed-income vehicles for people in their 70s. My guess is the annuities in the above example are "the rule", and not the exception, because of relatively low commissions. I'd be hard-pressed to recommend a 412(i) for principals of that age.

Outside of the qualified plan design world, immediate annuities are great for people in their 70s and older who are very interested in high monthly income, for living expenses or whatever.

[AndyH]

I could be convinced of that if there a reasonable conversion from a single dollar amount to an annuity, i.e. reasonable interest, reasonable mortality, and reasonable commissions and profits. With a 10-14 year likely time horizon, how can this be?

[Guest tonymascia1]

Andy,

The best thing I can do is refer you to www.immediateannuities.com, and have you play with some examples.

The distributed rates of return (which include principal and interest) work out very very well for those people not really interested in "leaving a legacy" but do enjoy regular cash flow".

[SoCalActuary]

I would add to Tony's comment. An immediate annuity eliminates two other issues:

1. The funds are safe from potential predators.

2. The risk of out-living your funds is zero.

I personally know too many people who cannot manage a portfolio in their senior years, and look for the current "best deal", assuming everyone is honest. Those capable of managing investment risk are fewer than those not-capable in the Medicare crowd.

However, we still have to worry about the deals that have hidden downside risks, including hidden sales charges and surrender charges.

Back to the original question, for the 76/70 yr old couple, you should be able to get a decent spread of contribution rates over the remaining employees using a cross-tested DC or possibly DB plan, or both if they can handle the expense.

Investing in an annuity product is a separate investment decision that should be appropriate for the level of sophistication and risk that the consumer is willing to bear.