Defined Benefit plan formula options

[Belgarath]

Just wondered if anyone had any thoughts on the following - excerpt from a discussion among "DB people" - which I am not!

A little background - fairly young - mid-30's S-corporation owner, no employees, app. 200,000 in high 3-year average compensation, looking to potentially start a DB plan. The discussion was on which method to use to get maximum contribution, and whether there are any potential downsides to using the 10 year approach? I'd appreciate any thoughts.

When designing a new plan, and coming up with a formula, I have usually been taking the conservative route and using a unit credit formula that funds for 100% at NRD when taking into account the number of years to retirement.

So for example, if a 40 year old was interested in setting up a one-person DB plan, and wanted to know what type of annual contribution he could expect, I would probably set up a 4% per year formula for 25 years of participation assuming NRA of 65. My question is in this example, could I do 10% for 10 YOP? This person would be limited by the 415 $ limit and I'm just trying to figure out what the plan would look like once he's accrued the full benefit. There may be COLA increases for the 415 $ limit, but otherwise wouldn't he be keeping the plan for 15 more years (age 50 to age 65) with the chance that there may not be much in the way of deductible contributions during those years? I just don't know if I have flexibility to use a formula that accrues the benefit quicker than the number of years to retirement. If so, would it make sense to do so if someone is interested in higher annual deductions now.

Response:

The formula is limited by IRC section 415, which phases in the DB dollar limitation over 10 YOP and the 415 percentage of compensation limitation over 10 YOS. For a very-high-paid owner, the DB dollar limitation will be lower, and hence will apply. Thus, even if you give a 100% per YOP formula, the 415 limit regulations effectively converts the formula into a 10% per YOP formula for the very=high-paid participant.

The 10% x (YOP not > 10) x AvgComp is the most common formula I see for one-person plans. It is simple, easy-to-understand, and it corresponds approximately to the DB 415 limit phase-in.

[Belgarath]

One other question that popped up - any thoughts about what the 10% for 10 YOP might do if plan is terminated after 10 years? I'm guessing that this wouldn't ordinarily be a problem? If not enough assets, a dump-in would be required, or he would have to "forego" some benefit. If too much in assets, could establish a replacement plan and allocate over 7 years if he's still working.

Any thoughts on a particular downside (or upside)?

Thanks!

[FAPInJax]

I have seen plans with a normal retirement age of 62 and fully subsidized at 55 (even earlier with some firms). The 10% per year approach can 'easily' be funded because in the second year and later the infamous 'cushion' calculation helps and the new differentiation between the minimum and maximum interest rates. The problem comes up when the assets start getting decent rates of return and the liabilities are not growing at a similar rate. It just requires keeping a close watch on the assets versus the 415 lump sum at every point in time and monitoring the current and future expectations.

[david rigby]

In general, the plan design should be strongly influenced by the owner's expectation of cash available for contributions, now and in the future.

- For example, if he/she expects cash to be much more available 10 years from now, then the accruals need not be rapid now. The benefiit formula can be amended at a later date.

- Dovetail this with the owner's expectation of when he/she wants to retire and/or sell the business. For example, working until 55 gets you a different design (and pattern of contributions) that working until 62.

- Don't forget about the death benefit.