Abusive Cash Balance formulas

[wsp]

Prefacing this by saying I'm not a DB guy so pardon the ignorance...

Tax client of ours added a DB plan to DC-New Comp plan. Deductible contributions more than doubled and client talked about how 90% of contributions are going to him and his wife. Which of course drew our attention. Client has always "pushed the envelope" in terms of tax issues. Now we are wondering if he is doing the same with this approach to retirement planning. At our request, the client provided us with current year allocation schedule and we have found that the plans are New Comp and Cash Balance plan.

I've read through a few things on the Cash Balance plan but as one might think they don't talk about the areas where the laws can be pushed and potential for abuse might exist. What I'm afraid of is that someone sold him on something along the lines of an abusive 412(i) plan but using the Cash Balance plan as it's vehicle. Is this something that could possibly blow up on him down the road? Is there a possibility of a reversion of some sort? If there is potential for problems down the road, is there something that will specifically point me to where to look to see if this plan falls within the acceptable versus nonacceptable realm? Do I look at coverage? Turnover? Inability to fund long term?

I want to be clear that I don't think the client is specifically doing anything wrong or that the investments are inappropriate, just that the plan may not necessarily be in his best interests in the long term. I think that we would be remiss if something were to be looming on the horizon and we didn't let him know; even though we weren't specifically engaged on the retirement plan piece. Could be perfectly legitimate and we clap him on the back and say good job. Just want to make sure.

Thanks in advance...

[Guest Carol the Writer]

Let me address the only specific issue about DB/DC combo plans that I know for sure. The only DC plan that can be combo'd with a DB plan (where a participant is in one plan or the other but not, in general, both) is a non-integrated profit sharing plan. That is, the participants in the profit sharing plan all receive a contribution that is a uniform percent of compensation for all participants. A DB/DC combo arrangement cannot have class distinctions as to contributions, such as one finds in a new comparability plan.

As far as deductibility, there were new opportunities for this under the Pension Protection Act of 2006, starting for 2006 plan years, which they may legitimately take advantage of. Also, they could have 401(k) features in their DC plan which would give them added weighting of contributions/benefits in their favor.

As far as the choice of a cash balance plan for the DB plan, whether it works out or not can only be known as the design and funding of the plan unfolds over the years. You cannot really say, going in, that it was a good idea or a bad idea. Code Section 415 limits need to be monitored annually to check for potential overfunding. It's just an operation issue. Abusive? Only the courts know for sure, although Congress give legal clarification to going-forward, new cash balance plans.

Good luck. You've raised a lot of questions, but the actuarial business (profession) concerns itself with charting a path through an unknowable future.

[SoCalActuary]

Sorry, Carol, but I disagree.

If the combo plans are used in a floor-offset arrangement, then I would expect the profit-sharing plan to have a uniform allocation formula. But that is the exception.

But if each plan can pass 410(b) separately, then each plan can be general-tested under 401(a)(4) separately with non-uniform benefit provisions. The only restriction is that only one of the plans can use imputed disparity for testing.

Even if the plans are aggregated for testing purposes, each can have a non-uniform benefit formula. But the combined total of the two plans must pass each of the 410(b), 401(a)(26) and 401(a)(4) testing rules.

To WSP:

Engage the services of a competent actuary who has done this work before. If you believe that the plans are abusive, be prepared to have technical explanations to back it up, because the authors of the proposed plans should be prepared to back up their work. If you are over your head on the technical issues, either pass on the assignment or bring in someone to make you competent to judge the issues.

[Penman2006]

"A DB/DC combo arrangement cannot have class distinctions as to contributions, such as one finds in a new comparability plan."

I have a number of DB/DC combos that have different DB benefits for different classes and on the DC side different allocations for different classes (including some DC plans with each partcipant in their own class). I have submitted to the IRS and received approval. There are some coverage testing quirks when the DC plan has each person in their own category and that has been discussed in detail on this board, but in general I know of no reason why there cannot be class distictions in a DB/DC combo.

[John Feldt ERPA CPC QPA]

SoCal and Penman are correct. We have a large number of DB/DC combo plans where the 401(a)(4) testing is done on a combined plan basis. See §1.401(a)(4)-9(b).

One of the more common items that may have a slight tendency to be overlooked is the 401(a)(26) issue that the benefits provided in the cash balance plan would need to be meaniningful for at least 40% of the participants (or 50 if that is less). Paul Schultz's IRS memo, but widely used as if it were part of the legislation itself, would generally indicate that a meaningful benefit would need to be equivalent to an accrual of at least 0.50% of pay per year payable at normal retirement. So in a cash balance plan, the credit to the "account balance" would need to be projected to normal retirement and converted to determine if they are truly participating in the plan in a meaningful fashion.

There are mathematical oddities that occur because of the Paul Shultz memo, but that's another topic for another day.

[wsp]

Thanks for the responses thus far....

SoCalActuary, my original intent was to go to an actuary with this but thought I'd first make sure that I wasn't wasting his time and my money. I realize that there is potential for abuse in any plan...just wanted to make sure that the cash balance plan wasn't today's 412(i). Your comments on the testing has actually helped and I've started the process of consulting with an actuary on it.

One question though: How does the gateway play into this? On my schedule there are a few individuals only receiving 3% in P/S plan and no one (besides owner and spouse) gets over 2% in Cash Balance Plan. In some cases they get both, but not all. Doesn't gateway apply here? Would it be applicable on a plan basis or aggregate? Assuming that imputed disparity was used for both plans and thus the plans are being tested on the aggregate.

[SoCalActuary]

Very good question - and you should be able to get a clear answer from the author of the proposal.

But remember also that the gateway does not apply if the plan is "primarily DB in nature" where the

benefit accrual rates for the majority of NHCEs is higher in the DB than in the DC.

In addition, the plans can avoid the gateway if benefits are smoothly increasing in the DC based on age or service.

The 5% DC only gateway or the 7.5% DB gateway get all the attention, but the rules are more flexible than that simple approach.

[wsp]

Very good question - and you should be able to get a clear answer from the author of the proposal.

But remember also that the gateway does not apply if the plan is "primarily DB in nature" where the

benefit accrual rates for the majority of NHCEs is higher in the DB than in the DC.

In addition, the plans can avoid the gateway if benefits are smoothly increasing in the DC based on age or service.

The 5% DC only gateway or the 7.5% DB gateway get all the attention, but the rules are more flexible than that simple approach.

As little as I have learned in the last 2 hours has told me that I won't get the correct answer from them, just an answer.

Can you avoid the gateway in a DC only plan by using the same principal?

[Mike Preston]

How are you intending to use the principal?

[SoCalActuary]

The principle behind the age-weighted plan or the old target-benefit money purchase plans allows a DC plan to avoid the uniform gateway for cross-testing.

You should read a summary of these rules, which have been with us for a few years now, in any of the current references like Pension Answer Book or Sal Tripodi's materials. If you really want to get into this, go to a specialized program such as the Larry Deutsch Non-Discrimination Symposium.

[wsp]

Thanks SoCal, much appreciated. I've got the Outline Book and read up on what you were talking about. Time to get a bit more aggressive in my ongoing education.

And, Mike....You'll be happy to know that the Principal has informed me that I can no longer use it in any form. Muttered something about basic spelling errors and walked away.

[Mike Preston]

Principle, principal, all the same to me. I just didn't know what you were referring to and I still don't. Such is life.

[wsp]

Principle, principal, all the same to me. I just didn't know what you were referring to and I still don't. Such is life.

Ah...now I got you. I was wondering if the smoothly increasing benefit to avoid the gateweay worked on a DC only plan or if it was limited to DC/DB hybrids. I was thinking that they were somehow able to avoid it based more upon the aggregation of the two plans and the extra benefit provided by the DB plan rather then solely on the smoothly increasing benefit on the DC side.

After heeding SoCal's advice I looked it up in Sal's book and saw indeed that one can avoid the gateway in that way. But, that brings up a different question....must every band have a participant representing that band? Seems to me if you've got the majority of your employees in the early bands you can save plenty of money if you are skipping most of the later bands.

[Mike Preston]

The bands are theoretical. There is no need to have any specific dispersion of participants.