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Session 407 - Small Plan Design
and Technical Issues
Presenters: Lawrence Deutsch and Thomas J. Finnegan
Recorder: Susan E. McDonald

There are several issues that present problems in small plans.

First Year Problem

PPA defines the maximum deductible as the greatest of:

-         the minimum required contribution

-         the funding target plus target normal cost plus the cushion amount less assets

-         the At-Risk funding target plus target normal cost less assets.

The minimum required contribution is “loosely related” to the amount to be contributed.  The minimum required contribution is equal to the lesser of:

-         the funding target plus the target normal cost less the assets

-         the target normal cost plus the shortfall amortization

The cushion amount is equal to the sum of 50% of the funding target and the amount the funding target would increase, taking into account future salary increases.

If there is no past service benefit, then the funding target is zero.  In the first year, the assets are zero.

If the prior formulas are re-written with no funding target and no assets, the result is that the maximum deductible contribution equals the target normal cost.

This is a problem on two fronts:

-         no allowance is made for required interest on contributions made after the valuation date

-         the desired contribution may be more or less than the target normal cost

The solution is to move part of the first year’s accrual into past service.

Example 1

Consider a plan where the desire is to have an accrual of 8% of final average pay per year and consider that this generates a target normal cost of $120,000.

If the plan is written so that the minimum accrued benefit for any participant on the effective date is 8% of pay, this makes life much better.

The accrued benefit at the end of the year is the same.

401(a)(4) is unaffected.

Assuming that the plan relies on the fractional accrual rule, accelerating accruals is not a problem.

Assuming that 8% of pay is less than 1/10th of the dollar limit, 415 is not a problem.

The full first year accrual is converted from target normal cost to funding target.

Because the assets are zero, the full funding target is a shortfall.  The amortization of $120,000 is roughly $20,000, so the Minimum Required drops from $120,000 to $20,000.

With a funding target of $120,000, the cushion amount is $60,000, ignoring any additional amount due to future salary increases.  So the maximum is $180,000.

By providing the full first year’s accrual as past service, the first year funding range has been converted from a minimum of $120,000 plus interest and a maximum of $120,000 to a minimum of $20,000 and a maximum of $180,000.

Example 2 

Assume that instead of a final average pay plan, this had been a cash balance plan with a hypothetical contribution of $132,000 but a target normal cost of $120,000.

Converting the entire hypothetical contribution of $132,000 into an opening balance of $132,000 would produce the same effect as Example 1.

The problem is that the accrual during the year would be zero.  If there were any accrual during the second year, the plan would violate the 133 1/3% rule; there would be backloading.

To avoid violating the 133 ½% rule, the accrual in the second year cannot be more than 133 1/3% of the accrual in the first plan year.

If the accrual in the second plan year is going to be $132,000, then the accrual in the first plan year must be at least $99,000.

If the accrual during the first plan year is $99,000, and the accrual at the end of the second year is $132,000, then the maximum pas service benefit (or opening hypothetical account balance) is $33,000.

This analysis ignores the effect of the hypothetical interest credit, which would allow for a slightly larger (maybe 2%) opening hypothetical account balance.

If ¼ of the first year accrual is made past service, then the funding target is $30,000 and the target normal cost is $90,000.

In turn, that makes the shortfall $30,000, the shortfall amortization $5,000 and the cushion amount $15,000.

This makes the minimum required $95,000 plus interest on contributions made after the valuation date.  The maximum is $135,000.

Now the plan sponsor can contribute the hypothetical contribution of $132,000.  (There is a typo in the meeting handout; the handout states $130,000.)

The 2/3s Plan

Example 3

The use of the funding cushion as part of the funding leads to the 2/3’s plan design.

Assume that the desire is to fund a plan of 6% of pay.

If the plan is designed at 4% of pay, then this funding objective can be met.

First, assume that there are no employees other than the owner, there never have been and there never will be.

Assume that the funding target associated with 1% of final pay is $15,000

Assume that technical corrections are made so that the cushion includes the funding target, which is the #1 item on the list to get corrected.

The plan sponsor wants to contribute $90,000.

One approach would be to make the plan 6% of pay.

Another approach would be to make the plan 2/3s of that amount, or 4% of pay.

At 4% of pay the target normal cost would be $60,000.

The cushion amount would make the maximum deductible amount $90,000.

This continues for 5 years, at which time the assets are $540,000, and the funding target is $360,000.

At this point the formula is amended up from 4% to 6%, increasing the funding target (and the 417(e) lump sum) to $540,000, the benefit is paid and the plan is terminated.

Example 4 

Now, assume that the plan has some employees but there is no turnover.

The formula, on an ongoing basis, is 4% of pay.

401(a)(4) testing is done based on 4% of pay.  PBGC premiums are based on 4% of pay.

The adjusted funding target attainment percentage (AFTAP) calculation is based on 4% of pay.

In the final year the formula is increased to 6% of pay.

If the plan is DB only, the employees will be made whole to 6% of pay.

If the plan is DB/DC and tested on an annual basis, the DC contribution will jump through the roof to support a one-year accrual of 14% of pay for the owner.

If the plan is DB/DC and tested on an accrued-to-date basis, the DC contribution will jump through the roof to increase the account balance to a level to support 6% per year rather than 4% per year.  The 7 ½% gateway in the DC plan could support 4% and 6% increases.

If there has been turnover, the prior participants’ benefits will have to be increased in order not to violate Example 1 of 1.401(a)(4)-5.  “We are cooked here.”

The bottom line is as follows:

-      For an owner-only plan, this can add significant funding flexibility.

-      When there are employees but no turnover, this adds funding flexibility, but no ultimate cost savings for employee costs.

-      When there are employees and turnover, this is a potentially dangerous road.

DB/DC with Cash Balance

The first knee-jerk reaction to PPA may be that a cash balance plan is simply a DC plan with DB 415 limits.

For many reasons, this is not true. One reason is plan design.

From a design perspective, a cash balance plan is superior to a more traditional DB design for several reasons

-         Transparency

-         Long-term cost control

-         Staff cost containment

Transparency

Since the lump sum required to be paid can be set as equal to the hypothetical account balance, a cash balance plan takes much of the mystery out of a defined benefit plan from the client’s perspective.

It is easier for partners to understand what each partner’s cost is and how much of the liability is attributable to each partner.

Long Term Cost Control

Because there will generally be a close coordination between hypothetical contribution and real contribution, and the hypothetical contribution pattern is very predictable, the future costs are more predictable from a client perspective.

Staff Cost Containment

In a traditional plan, a single older staff member can have a significant cost, in comparison to the average staff employee

In a cash balance plan, the older employee has the same cost as the younger employee

So then, why not just have a single cash balance plan?

The problem lies in two areas, top heavy minimum and the combination of interest rate and testing.

Because the top heavy minimum in a defined benefit plan is a traditional type benefit, it can be expensive.

For a new hire, age 60, the top heavy minimum is equivalent to a hypothetical contribution of roughly 20% of pay, or more when salary increases are taken into account.

In a DB/DC with cash balance, the top heavy minimum is provided as a DC allocation of 5% of pay.

Even for a 35 year old, this is generally less expensive than the top heavy minimum in a defined benefit plan.

The second issue is the combination of interest rate and testing. 

The 415 limit is about 8% of pay at age 62.

Consider a cash balance plan with a hypothetical interest rate of a fixed 5%, retirement age of 62, and the owners normal EBAR (employee benefit accrual rate; normal accrual rate) is 8% and the most valuable EBAR (most valuable accrual rate) is 10%.

The employee the plan “turns on” is age 32.  This means the age 32 employee must have a normal EBAR of 8% and a most valuable EBAR of 10%.

In a cash balance plan, the hypothetical contribution would have to be 23.5% of pay to generate an EBAR of 8%.  At 23.5% of pay, the most valuable EBAR would be 21%.

On the other hand, in a DC plan, a contribution of 7.4% of pay would generate an EBAR slightly in excess of 10% at age 62.

In this case, the minimum aggregate allocation gateway (MAAG limit) would likely require an allocation of 7.5% of pay.

Pushing the Maximum

In a traditional plan, pushing the 415 limit is generally a plan formula of 8% of pay, with retirement at age 62.

In a cash balance plan, life is more complicated.  The first issue is interest rate.

If the hypothetical crediting rate is higher than 5%, it would appear that the immediate lump sum at ages below age 62 is reduced, because adjustment for ages below 62 would be done at the higher rate. 

If the hypothetical crediting rate is lower than 5%, then ground is lost on the testing.

Using a similar analysis, the optimal conversion rate for 415 is the greater of 5.5% or the rate that produces 105% of the benefit using 417(e) rates.

Thus, it would appear that the optimal assumptions for a cash balance plan pushing the 415 limits is 5% interest as a hypothetical rate and 5.5% interest for conversion to an annuity.

The problem comes in determining the correct hypothetical contribution when the interest rate changes because of a change in the 417(e) rate.

One choice is to allow the account balance to be greater than what is necessary to produce the 415 limit, but then why have the cash balance in the first place?

So consider what happens if the conversion rate goes from 5.5% to 6%, as will most likely happen between 2008 and 2010 because of the phase-in rules.

Consider the 415 limit is $185,000; consider the participant is age 55 in year one.

One tenth of the 415 limit in year one is $161,860; 1/10th of the 415 limit in year two is $162,654.

If year one is the first year in the plan, the hypothetical contribution is $161,860.

In year two, the hypothetical account balance, prior to contribution is $169,953 ($161,860 times 1+i).

The desired hypothetical account balance is $325,308, which is 2/10th of the 415 limit as a lump sum.

So the hypothetical contribution is $155,355, which is what gets the participant to the 415 limit, reduced by the prior account balance.

If instead, in year one the participant has 7 years of participation, then the hypothetical account balance is $1,133,020.

In year two the hypothetical account balance, prior to contribution, is $1,189,671.

The desired hypothetical account balance is $1,301,232, which is 7/10th of the 415 limit as a lump sum. 

This makes the hypothetical contribution in year two equal to $111,561.

All other things being equal, the hypothetical contribution in year three would be $170,787.

This would be an increase in the accrual of 45.8%, when taking the adjustment for interest into account. ($170,787 – $111,561 * (1+i))

So the plan would violate the 133 1/3% rule and be disqualified.

The bottom line is, if the intent is to be at the 415 limit, it might be worth just providing the 415 limit and not having a cash balance plan.