Cash Balance vs Defined Benefit

[MGOAdmin]

I have a potential client that has 3 owners and no employees. They would like to set up a plan to defer some of the taxes.

Is there any benefit to setting up a cash balance plan vs. a defined benefit plan? Or does it not matter since there are no employees and therefore no discrimination testing? Note - there will never be any employees.

Thanks

[Belgarath]

Not discussing the relative merits of one vs. the other, as there are folks here far better qualified to do so, but a cash balance plan IS a defined benefit plan.

[Calavera]

It is easier to reach an agreement between owners on the level of contributions, and/or tax deductions under a cash balance defined benefit plan,than under a standard defined benefit plan.

[MoJo]

I'll bite.... What's the ultimate goal of the owners/company in setting this up? Different "benefit formulas" (i.e. either a cash balance formula or a more traditional formula - of which their are many...) will determine whether the goal will be accomplished (and at what cost/administrative complexity, etc.).

[MGOAdmin]

They just want to maximize each year - they are different ages, so obviously the contributions will be different for each partner

[QDROphile]

Will you be able to explain to them the risk that they will be subsidizing each other's benefit? That is not immediately obvious in a cash balance plan.

[My 2 cents]

In a cash balance plan, especially if one is dealing with people below Normal Retirement Age, the amount required to be contributed is not going to generally equal the value of the year's accrual.

I think they are looking for a plan where they can keep track of individual values, like in a defined contribution plan, but not subject to as low a contribution limit. But it is not a defined contribution plan and it is not that unlikely that differences will arise.

Of course, it is possible for a cash balance plan, due to Section 436 of the IRC, to have to place restrictions on distributions. If that were to happen, one or more of the owners might not react well.

[Peter Gulia]

What about three pension plans, so each owner makes his or her plan-design decisions, funding decisions, and investment decisions, and so none of the owners subsidizes another?

[Doghouse]

Sadly, Peter, 401(a)(26) kills this concept.

[Peter Gulia]

I'm showing my lack of memory that results from not using the information in work experiences.

While I've advised trustees of defined-benefit pension plans, I've never designed a plan that needed to worry about the 401(a)(26) rule.

Doghouse, thank you for reminding me about that constraint.

[david rigby]

They just want to maximize each year - they are different ages, so obviously the contributions will be different for each partner.

Different ages is not surprising. Also important is how much different, and what ages?

If the ages are 50,51,and 52 the next step will not be the same compared to ages 30,31,and 32.

[Hojo]

In a cash balance plan, especially if one is dealing with people below Normal Retirement Age, the amount required to be contributed is not going to generally equal the value of the year's accrual.

I think they are looking for a plan where they can keep track of individual values, like in a defined contribution plan, but not subject to as low a contribution limit. But it is not a defined contribution plan and it is not that unlikely that differences will arise.

Of course, it is possible for a cash balance plan, due to Section 436 of the IRC, to have to place restrictions on distributions. If that were to happen, one or more of the owners might not react well.

I think this is overcomplicating the matter a bit. If the owners are looking to maximize contributions (as is usually the case) then the 436 restrictions would rarely come into play. Additionally, as you state, the amount required to be contributed is not going to generally equal the value of the year's accrual, but luckily enough for the sponsor can contribute more than the minimum amount required (in the first year this is generally equal to the accrual and then increases almost exponentially).

Unless they are looking for a big one year contribution and can use past service there is little difference between using a traditional DB or a CB plan.

[AndyH]

I once took over a Cash Balance plan which set the annual pay credit for the owners to equal their maximum under 415. Fun stuff since few people would agree on what that actually means.

[Zoraster]

Why setup a traditional DB plan? Creating liabilities that could extend for decades and have to be administered just doesn't seem cost effective. The cash balance pension for small groups of employee/owners is a good mechanism to put cash away well in excess of the 401 limits. Popular with attorney and doctor firms; individuals with big salaries that are reverse discriminated due to 401 contribution limits.

[Effen]

Zoraster - "cash balance" or "traditional" are simply methods of determining the amount of benefit payable at some event. They have nothing to do with the benefit delivery. Cash balance plans don't have to pay lump sums, and traditional plans can offer forms of payment other than annuities.

The big advantage of cash balance plans in the small plan market is the ability to control the cost of the benefit and to allocate the same "value" of benefits to people of different ages/compensation levels.

[My 2 cents]

Zoraster - "cash balance" or "traditional" are simply methods of determining the amount of benefit payable at some event. They have nothing to do with the benefit delivery. Cash balance plans don't have to pay lump sums, and traditional plans can offer forms of payment other than annuities.

The big advantage of cash balance plans in the small plan market is the ability to control the cost of the benefit and to allocate the same "value" of benefits to people of different ages/compensation levels.

In my experience, cash balance plans fail to control costs the same way that defined contribution plans do. Still subject to minimum funding rules, contributions not generally equal to pay credits, etc.

The idea here is presumably to create something allowing larger contributions than would be permitted under a defined contribution plan, but don't forget that the PBGC takes a cut, investment losses (or reduced discount rates etc.) have to be amortized over 7 years, and just think for a second what will happen when (if) the IRS requires the use of Society of Actuaries mortality rates.

[Effen]

2 Cents - not sure what your point is. Obviously defined benefit plans are different than defined contribution plans and therefore they won't work in the same way. If anyone ever told you cash balance plans control costs the same way defined contribution plans do, they were flat out wrong.

Also, not sure what you are implying about when IRS will require the new SOA mortality tables. It is definitely coming, most likely for 2017, but it will have no impact on most cash balance plans.

It will however push up lump sum values and funding requirements in traditional defined benefit plans.

[My 2 cents]

2 Cents - not sure what your point is. Obviously defined benefit plans are different than defined contribution plans and therefore they won't work in the same way. If anyone ever told you cash balance plans control costs the same way defined contribution plans do, they were flat out wrong.

Also, not sure what you are implying about when IRS will require the new SOA mortality tables. It is definitely coming, most likely for 2017, but it will have no impact on most cash balance plans.

It will however push up lump sum values and funding requirements in traditional defined benefit plans.

Did not make myself clear - My point was that cash balance plans do not control costs well at all.

As for the impact of the SOA mortality tables, unless one assumes no pre-retirement mortality, the SOA tables will impact the funding target of people in a cash balance plan who are not yet at the assumed retirement age. The funding target for people not yet at the assumed retirement age cannot be just set equal to the current account balance. The funding target will reflect interest accumulations to assumed retirement age based on the plan's interest credit rules and then discounting at the segment rates (and, if pre-retirement mortality is assumed, with mortality for the deferral period) back to the valuation date. The expected pay credit for the year, similarly, cannot just be used as is as the target normal cost. These things can operate in unpredictable ways.

[Hojo]

2 Cents - not sure what your point is. Obviously defined benefit plans are different than defined contribution plans and therefore they won't work in the same way. If anyone ever told you cash balance plans control costs the same way defined contribution plans do, they were flat out wrong.

Also, not sure what you are implying about when IRS will require the new SOA mortality tables. It is definitely coming, most likely for 2017, but it will have no impact on most cash balance plans.

It will however push up lump sum values and funding requirements in traditional defined benefit plans.

Did not make myself clear - My point was that cash balance plans do not control costs well at all.

As for the impact of the SOA mortality tables, unless one assumes no pre-retirement mortality, the SOA tables will impact the funding target of people in a cash balance plan who are not yet at the assumed retirement age. The funding target for people not yet at the assumed retirement age cannot be just set equal to the current account balance. The funding target will reflect interest accumulations to assumed retirement age based on the plan's interest credit rules and then discounting at the segment rates (and, if pre-retirement mortality is assumed, with mortality for the deferral period) back to the valuation date. The expected pay credit for the year, similarly, cannot just be used as is as the target normal cost. These things can operate in unpredictable ways.

I think you may not understand these plans as much as you think you do, especially in the small plan market where no pre-retirement mortality is a standard assumption and the PBGC hit is minimal at best.

In addition, with a cash balance plan, the minimum required contribution will rarely, if ever, be as much as the value of the contribution credits. There's really very little unpredictability unless the plan sponsor decides to fund in unpredictable ways or has a very unpredictable cash flow. If the plan is set up correctly and the sponsor funds the contribution credits annually, the plan will last for 10 years with much higher deductions than a DC plan alone and have very little volatility.

[Effen]

Agreed. I think the mistake people make is assuming that target normal cost and funding target have anything to do with reality. Bad consulting will produce bad results and there is a lot of bad consulting out there, especially with the TPAs that use a "signature for hire" actuary.

Assuming interest crediting rates are less than funding rates, the funding target is generally lower than the hypothetical cash balance. This produces a Minimum Required Contribution that is typically less than the amount necessary to keep the plan 100% funded based on actual account balances. Also, as the plan matures, the maximum deductible will generally be significantly more than the amount necessary to keep the plan 100% funded.

We typically talk to our clients about "recommended" contributions that will keep the plan 100% funded. Getting that recommended number to fit within the minimum and maximum usually isn't a problem, but it certainly could be if rates move dramatically.