Is your firm looking to offer more options around your current retirement plan? You might want to consider a cash balance plan as a potential wealth-building option for your leadership team. A cash balance plan is ideal for professional service firms who want to set up a plan to achieve qualified retirement plan tax deferrals in excess of defined contribution 401(k) plan limits. In the case study below, we walk through the benefits of implementing a successful new cash balance plan for a large regional law firm.
A large regional law firm wanted to provide greater tax-deferred wealth building and retirement saving opportunities for their partners. Most partners were maximizing their 401(k) deferrals but were limited by their current 401(k) plan’s annual contribution limits. A key concern was that the partners could not accumulate enough savings to maintain their standard living in retirement through the 401(k) plan alone. The partners had been saving personally, but recognized that current taxes and higher retail investment fees were significant impediments to meeting their goals.
Another key concern was that they didn’t want to end up with a plan that had an unfunded liability requiring active partners to fund benefits for retiring partners. They wanted the contributions funded by each partner to be returned to each partner at retirement along with the earnings from the pension trust.
We recommended a cash balance plan as the solution that would allow partners the ability to defer significant additional income, tax-deferred. Also, the plan was designed to credit participants’ cash balance plan accounts with the actual portfolio investment return within certain limits, to avoid any unfunded liability occurring due to investment performance. Because this firm has more than 50 partners, we were able to design a highly cost-effective, tax-deferred cash balance plan for partners only.
How the Plan Works
The partners make annual contributions based on a predefined formula and their cash balance account grows with the actual return on the plan’s assets. The formula requires contributions based on partners’ budgeted compensation for a year. Partners with higher budgeted compensation make larger contributions to their account. The annual contributions range from $5,000 to $200,000. The returns are determined on a daily basis. The partners can access their account balance at any time using our online administration portal, RetirementFocus™. This allows them to see their daily account balance based on actual daily plan returns. When a partner retires, they receive the value of their account balance as a lump sum payment.
Technical Issues Addressed Through the Design
In order to satisfy the hybrid pension plan rules there were some constraints placed on the design and operation of the plan. Our task was to design the plan so that all requirements could be met by design and any required compliance testing could be easily passed, avoiding any negative surprises. A maximum investment return and cumulative minimum investment return limit were applied to the cash balance accounts. However, the plan’s investment strategy has been crafted so these maximum and minimum investment return limits should rarely come into play.
In order to satisfy benefit accrual rules, the plan was designed so that the accruals would change at certain ages but would change gradually. We modeled different accrual patterns for the partners to ensure the plan had enough margins to pass the testing on an annual basis while providing significant deferral opportunities for the partners. To satisfy annual coverage, minimum participation, and nondiscrimination testing to prove the plan does not unfairly discriminate in favor of the partners, the firm provides a 7.5% profit sharing to all non-attorney staff.
Cash Balance Plan Results
The plan continues to provide significant savings opportunities for the firm’s partners especially as they get closer to retirement age. In the short time the plan has been in existence, senior partners who are close to retirement age have been able to defer and accumulate cash balance accounts in excess of $1 million.
In addition, the plan continues to pass all annual regulatory testing requirements. We developed an annual streamlined process to provide the firm with timely testing results, appropriate partner contribution amounts and actuarial valuation results. In addition, we developed a process to assist the firm’s staff with annual retirement calculations support when needed. These steps allow the firm’s staff to focus their time on other important benefit issues while the cash balance plan runs fairly autonomously.
This solution was developed specifically for a law firm but many other organizations can take advantage of this solution as well. Professional service firms such as physicians, architects, engineers and accountants should consider this plan design, as well as any other organization that has executives with the same challenges described here. If you have further questions, please contact Larry Scherer in the form below to start the conversation on how this can benefit your firm.
Overview: For successful small businesses, a 401(k)
plan combined with a cash balance plan can provide opportunities to:
Build wealth and
retirement savings for the owners/ professionals with much greater
contributions than through a 401(k) plan alone
Save on federal,
state, and local taxes through higher deductible contributions
substantial assets from creditors or legal action
attractive retirement benefits for nonowner
retain talented employees
well-being and retirement readiness for all participants
The Tax Cuts and Jobs Act
substantially reduced corporate tax rates for C corporations, and added a
complex set of rules on deductions for pass-through entities such as
partnerships, LLCs, and S corporations. Fundamentally, tax reform enacted a
slightly lower individual tax rate (top brackets reduced from 39.6 percent to
37 percent) for high-earning owners, which means that these plans are still tax
effective, while the substantial long-term benefits remain unchanged. Business
owners who are currently sponsoring or planning to set up a 401(k) plan and
cash balance plan should talk with their tax advisor and actuary, to see if any
changes to plan design or their business structure are desirable.
the Tax Cuts and Jobs Act
A lot has been written and said
about the Tax Cuts and Jobs Act and the tax rule changes that affect
businesses. In this article, we focus on the very fundamental aspects of these
C corporations now have a flat 21 percent income tax rate and pass-through entities now have a 20 percent deduction on qualified business income. This 20 percent deduction is limited or phased-out based on the type of business and business income through very complex rules. For taxpayers in the top individual income tax bracket of 37 percent, this 20 percent deduction can be viewed as a 7.4 percent (20 percent of 37 percent top individual income tax rate) rate reduction.
Thus for most high-earning
owners and professionals, the evaluation of the tax effectiveness of their
401(k) and cash balance plan will involve only a change in tax rate from 39.6
percent to 37 percent. We’ve seen that this may cause subtle changes in design
and contribution levels, but it does not change fundamental decisions on
whether to adopt one or both plan types.
To illustrate how the
combination of a 401(k) and cash balance plan can be used, let’s look at a case
study of a professional firm we’ll call ABC Services.
Case Study: ABC Services
ABC Services is a partnership of any type of business professionals such as accountants, doctors, or lawyers. There are three partners in the business, each owning one-third of the practice. The firm has a number of nonowner professionals we’ll call associates. The firm employs other staff as well.
The partners at ABC have these goals for their retirement program:
Adam and Bill (both age 55) would like to maximize their retirement savings.
Carol (age 45) needs more current income and less saving for retirement. No
partner wants to subsidize the retirement benefit of the other partners.
the associates are ages 30 to 45. Associates prefer current compensation over
future retirement benefits. ABC wants to minimize retirement plan contributions
to this group.
Staff – ABC
hires relatively young staff and experiences moderate turnover among this
group. ABC wants to offer a market-competitive level of retirement benefits to
attract staff employees.
Tables 1A and 1B show the employer contributions provided under the
401(k) and cash balance plans established by ABC. Each participant can make
salary deferral contributions to the 401(k) plan up to the IRS limits,
including additional catch-up contributions for individuals age 50 and older.
Annual contribution amounts for ABC partners
*Subject to IRS limits
Annual employer contributions, as a percentage of eligible pay, by employment
Employer Cash Balance
How well does this retirement
program accomplish ABC’s objectives?
Partners – Adam and
Bill are able to receive contributions of (and defer tax on) $179,000 each year. Carol accomplishes her goal by having a meaningful, but
significantly lower, contribution
amount of $68,000 per year with
flexibility to change her contribution amounts through the 401(k) plan.
Associates – ABC minimizes retirement contributions for associates by providing a separate, employee
deferral only 401(k) plan for associates, and excluding the associates from the cash balance plan.
Staff – ABC offers a
strong benefit to this group in order to attract and retain staff employees.
The plan design provides employer contributions of 7.5 percent of pay for staff, plus employee 401(k) salary
deferrals and catch-up contributions if the employee
is at least age 50.
What Types of Employers Should Consider a 401(k) Cash
that any successful business can consider implementing a 401(k) and a cash
balance plan. We find, however, that businesses with the following
characteristics are the most likely to see the benefits of implementing these
owners are age 40–64
The business has
had consistent cash flow and
The future of the
business looks good, with positive cash
flow and profitability over the next five years
The ratio of nonowner
employees to owner employees is relatively low
The business has a 401(k) plan in place and is making employer contributions currently
Also, we frequently hear these goals in
discussions with owners of successful businesses:
We want (or need) to save more for retirement than the current
IRS annual limit imposed on the 401(k) plan
We want to reduce our current taxes
We need protection of assets from
creditors, or in the event of a lawsuit
We want to recognize and reward key
We want to
attract and retain the best employees
implementing a 401(k) plan and cash balance plan with advanced plan designs,
successful businesses can meet their owners’ goals for wealth building and
retirement savings and offer an attractive and cost-effective retirement
program to their employees.
Closer at Cash Balance and 401(k) Plans
retirement plans are divided into two categories: defined benefit (DB) plans
and defined contribution (DC) plans. Cash balance plans are a typical DB design
for small businesses and professional firms, while 401(k) plans are a common DC
A cash balance plan is structured to look like a DC plan with
each participant having a recordkeeping account that receives employer
contributions and interest credits. These interest credits are often defined
and guaranteed by the plan.
Since both 401(k) and cash balance plans are types of qualified
retirement plans, they share a number of common features that are important for
employers and participants:
Contributions are tax-deductible
Trust earnings are tax-deferred
Trust assets are protected from
the claims of creditors
usually immediately available after
termination, retirement, death or disability
distributions may be rolled over to a successor plan or another tax-advantaged plan
not subject to FICA or FUTA tax
Table 2 highlights the key differences between 401(k) and cash balance
Cash Balance Plans
Contributions (based on 2019 limits)
Participants can save up to $19,000 in before tax or Roth (after tax) employee savings
Participants age 50 or older can save an extra $6,000 in catch-up contributions
The employer and employee contributions can be up to $56,000 ($62,000 including catch-up contributions)
Employer contributions (match and profit sharing) are usually discretionary
Contributions can be far greater than current 401(k) limits, depending on the owner’s/professional’s current age
The cash balance account is guaranteed Additions to the cash balance account are based on pay credit and interest rate factors defined in the plan document
Employer contributions are required
Participants usually direct the investments in their 401(k) account
The participant chooses their investment strategy and bears the investment risk
Assets are invested in a pool for all participants in the plan, usually with a conservative investment strategy
Plans are allowed to credit the actual performance of the portfolio to participants’ cash balance accounts (certain restrictions apply)
The employer sets investment strategy and often bears all the investment risk
The participant’s account value is based on contributions and actual investment returns (or losses)
The participant’s account has guarantees; the account is based on contributions, interest credits as defined by the plan, and minimum guarantees required by law
In-service distributions are allowable for hardship or upon reaching age 59½
Distributions are usually as a lump sum, some plans allow for installments or purchase of an annuity
Participant loans are often available through the plan
In-service distributions are allowable at or after age 62
Distributions are usually made as a lump sum, annuity options are available through the plan
Loans are usually not offered
With examples showing the
benefits of implementing a 401(k) plan
and cash balance plan to owners and their employees, the natural question is:
why not implement these plans?
Business owners considering these plans should also
discuss these issues with their actuary, tax advisor, and plan consultants:
Higher contributions for nonowner employees will likely be required
There will be higher administrative costs for a second plan, including hiring an actuary to certify the minimum funding required of the cash balance plan
There may be PBGC premium expense for certain plans and employers; however, PBGC coverage can result in additional deductible contributions
There are annual required minimum contributions for the cash balance plan
Volatility in the investments held by the cash balance plan can lead to volatility in the required minimum contributions
Funding levels must be managed to avoid certain restrictions on distributions
The combination of a 401(k) plan
and a cash balance plan is often the best solution for a successful business
wishing to provide substantial tax-deferred savings for key individuals. This
combination of plans is easy to understand and can provide surprising
flexibility along with increased contribution limits.
The case study shown in this article shows the retirement
accumulation potential of implementing a 401(k) and cash balance plan. Other
cost-effective plan designs are generally available; for more information,
please contact your Findley consultant.
Are you considering or have you recently set up a cash balance plan? Does your organization have multiple owner-employees? You likely have been focused on plan designs to achieve your retirement and wealth-building objectives; it’s now time to address ongoing administration. This article describes several common administration issues and examines ways you can address these issues through planning and ongoing communication with your actuary, to further ensure the success of your plan.
Sharing the Ongoing Cost of the Plan
If your organization has multiple owner-employees and other staff, you and your fellow partners likely have a variety of business expenses that you share on a pro rata basis, a percentage ownership basis, or another basis that rationally spreads the business expenses across your partners. There are several significant decisions to address with your cash balance plan that you may want to handle differently than other business expenses:
Should partners agree to fund more than the minimum contributions to the plan early on to accelerate tax deductions, create contribution flexibility, and for other planning reasons?
How will partners share the contribution costs for non-partners participating in the cash balance plan?
If the cash balance plan is part of the strategy for partner succession, how does this affect the contribution and cost-sharing policies?
How will partners share the cost (or savings) on contributions when investment returns vary from the stated cash balance account investment return, and terminating participants leave with unvested cash balance benefits?
How will the partners share the administrative cost to maintain the plan?
Many ownership groups view the cash balance plan as a form of deferred compensation for themselves (i.e. ‘my money’). With this mindset, it may be appropriate for partners to share the non-partner contributions and administrative costs of the plan based on their annual contribution to the plan. However, the partner group should discuss the cash balance design, contributions, and the general expense sharing approach as a whole to ensure that partners understand the potential variations expected in sharing contributions and costs. Also, given the concerns that most partner groups have around investment volatility, we find that many plan sponsors establish a conservative investment policy to minimize the deviation of required contributions from participants’ cash balance account growth.
As you discuss your approach to sharing costs and contributions in your plan, you should consider potential future events as well. Your decision on sharing the contributions and administrative cost of the plan will establish the precedent for future event-driven decisions as your business evolves. The following are some common future events that should be considered when making your partner contribution and cost-sharing decisions:
Do you have any employees that you expect to become partners in the next 5-10 years?
Are any current partners expected to retire in the next 5-10 years? If so, are those partners expected to pay their share of the annual cost if they retire mid-year?
What happens if a partner leaves and the plan is overfunded or underfunded?
What is your expected time horizon for the plan? Is it 5-10 years, or longer?
When the plan eventually terminates, how will any funding shortfall or one-time expense be shared among the partners?
The bottom line: Either your entire partner group or a designated committee should discuss these general and event-driven issues with your actuary and investment advisor in order to develop a plan-oriented funding policy and investment policy. Once that is in place, you should consider developing a documented contribution and cost-sharing policy among your partners.
Addressing Plan Issues Arising from Workforce Changes
As your business evolves, you’ll likely have new employees and new partners, as well as turnover and retirements among existing employees. Any changes among your rank-and-file employee group, your highly compensated employee group, or your ownership group can trigger one or more of the following issues:
Nondiscrimination testing problems
PBGC coverage and associated premiums
Lump sum distribution complications, if the plan is underfunded or overfunded
The bottom line: As your workforce changes, alert your actuary to these changes as soon as possible. Ask that they review your plan for any potential issues and advise you of any options to consider. If decisions are needed, a quick review by your actuary ensures that you have maximized the time to decide your approach before any compliance deadlines.
Finishing Well – The Decision to Strategically Terminate the Plan
As your business evolves and your cash balance plan matures, your objectives for your cash balance plan may change as well. New objectives such as:
A desire to redesign the plan following significant growth, retirement of several partners, or a merger or acquisition;
Cash balance accounts and plan assets becoming significant, and the employer desires to limit risks associated with guaranteeing the interest crediting rate on larger balances; and
Partners wanting more control over the investment of their cash balance account, wishing to transfer their current cash balance account to an IRA or the 401(k) plan
can be trigger points to strategically terminate the current cash balance plan. It is also the time to consider whether to immediately establish a new, redesigned cash balance plan to fit the current workforce and ownership group. There are IRS regulatory and other requirements to consider, so the first steps in your decision to terminate should be discussions with your actuary and other advisors to determine if your plan is ready for a strategic termination.
We know that the only constant in business is change. With a well-designed cash balance plan, any issues you may face as a result of change in your business can be managed effectively. Effective management means thorough planning on your funding, investment, and cost-sharing policies, along with ongoing review and discussions with your actuary and other advisors annually and as events occur.