DESIGNING QUALIFIED RETIREMENT PLANS TO MAXIMIZE WEALTH ACCUMULATION

By David Wasserstrum, CPA, Richard A. Eisner & Company, LLP

Today's qualified retirement plan marketplace is dominated by 401(k) plans, under which eligible employees may defer a component of compensation on a pre-tax basis. Section 401(k) plans make fine employee benefit programs. But for business owners and key executives, traditional retirement programs combined with unconventional retirement plan contribution allocation techniques may provide very powerful tools as a tax shelter and for wealth accumulation.

When a plan sponsor's objectives include maximizing tax shelter and wealth accumulation for owners and executives, 401(k) plans fall short because--

* the maximum pre-tax contribution is currently $10,000, and

* a special discrimination test that applies to pre-tax contributions to the 401(k) plan may result in a taxable distribution to a highly compensated employee of a portion of his contributions.

Traditional defined benefit pension plans may provide an excellent vehicle to maximize benefits to owners and key executives. In addition, a number of age-sensitive allocation techniques may provide substantially disproportionate allocations to owners and executives in defined contribution plans (e.g., profit-sharing plans).

Defined Benefit Plans

A defined benefit pension plan generally provides for distributions to participants in the years after retirement. Retirement benefits are measured by, and based upon, such factors as years of service and compensation. Currently, the maximum annual benefit is limited to the lesser of $130,000 or an average of the participant's highest three years of compensation.

In order to provide the promised benefits, the employer must contribute, or fund, an actuarially calculated amount. One advantage of a defined benefit plan over a defined contribution plan is the ability to contribute amounts which exceed the limitations imposed upon defined contribution plan participants, i.e., the lesser of 25% of compensation or $30,000. These increases allow for greater tax deductible contributions.

Defined benefit plan values start accruing at a low rate during early years of plan participation and increase rapidly as a participant approaches normal retirement age--another difference from a defined contribution plan's value of benefits, which tends to accrue more evenly over the participant's working years. Thus, these plans often significantly benefit older, higher-paid owners and executives. Likewise, the cost of providing benefits to short-service employees who terminate is lower than the comparative cost in a defined contribution plan, though it may also be more expensive to fund a promised benefit for a participant nearing normal retirement age.

In defined benefit plans, the employer bears the risk of rates of return on assets, which may exceed the actuarial assumptions that form the basis of the funding requirement. These excess returns will automatically reduce required employer contributions. Alternatively, if the employer desires to amend the benefit formula under the plan, additional assets generated through actuarial gains may be utilized to increase benefits under the plan.

The cost savings available through defined benefit plans may not be apparent when the plan is initially designed, since future investment gains may not be anticipated. As a result, they are not reflected in the annual funding requirements when preparing an initial analysis of potential future costs.

A defined benefit plan will nevertheless be less expensive to fund than a defined contribution plan intended to provide similar levels of benefits at normal retirement age because--

* investment gains benefit the sponsoring employer, and

* the cost of providing benefits to terminating short-service employees is lower.

In addition to providing maximum benefits to key participants, defined benefit plans favor loyal, longer service employees. They may also be easier to administer than 401(k) plans because they are not subject to the 401(k) discrimination test, do not allow participants' involvement in plan asset investment decisions, and are generally accounted for annually.

Hybrid Defined Benefit Plans-- The Cash Balance Plan

The cash balance plan, another type of defined benefit plan, looks and operates like a defined contribution plan from the employee's perspective. The primary difference is that employees' investment earnings are unrelated to actual trust earnings. To the extent actual trust earnings exceed the investment earnings credit to an employee's account, the required employer contribution is reduced, and vice versa.

Participants in a cash balance plan receive annual contributions to their accounts, the amount of which may be based on years of service or age. In addition, investment earnings are credited on beginning balances and based on an interest rate or index defined in the plan.

The primary benefits of a cash balance plan include--

* all the advantages of a defined benefit plan as mentioned above.

* the ability to convert existing accrued benefits to an actuarially equivalent beginning balance in the cash balance plan. For example, where an employer sponsors an underfunded defined benefit plan and would like to introduce a defined contribution plan, they can amend--not terminate--the existing defined benefit plan into a cash balance plan. This avoids some of the burdens associated with terminating defined benefit plans, including immediate vesting, the need to make up funding deficiencies, and a variety of government filings.

* the ability of an employer that sponsors an overfunded defined benefit plan to use it to avoid a reversion of excess assets upon plan termination, which are subject to a confiscatory excise tax. Conversion to a cash balance plan would allow the employer to allocate excess assets toward future funding of participant benefits.

* its "user friendliness" for plan participants who look at their account balances to assess their benefits. A cash balance plan looks and operates like a defined contribution plan.

Age-Sensitive Contribution Allocation Techniques in a Profit-Sharing Plan

The amount necessary to satisfy the minimum funding requirement of a defined benefit pension plan must be contributed each year. When an employer prefers more power over the extent and timing of contributions, a "profit-sharing plan" might be of interest. This plan is a defined contribution plan that grows until the participant's separation from service, not retirement.

A profit-sharing plan is a flexible tool because--

* it allows for discretionary employer contributions up to 15% of eligible compensation,

* it permits distributions "in-service," i.e., before a participant separates from service,

* its distribution rules may be designed to avoid the spousal consent requirements of a pension plan, and

* it may incorporate a section 401(k) feature.

The maximum deductible employer contribution to a profit-sharing plan is 15% of eligible compensation, which may limit the employer who wishes to allocate a larger share of contributions to principals or highly compensated employees.

As Exhibit 1 illustrates, each employee receives an allocation equal to 15% of compensation, for a total employer contribution of $75,000, of which the owners receive $48,000, or 64%. Clearly this allocation method is simple and not discriminatory in favor of the owners, who perhaps should be rewarded for their greater responsibility and risk.

Age-Weighted and New Comparability Allocation Methods

Age-weighted and new comparability plans are generally profit-sharing plans and, consequently, are intended to permit discretionary employer contributions. In both, employers allocate contributions using a technique known as "cross-testing," which permits an employer to base contributions on defined benefit type factors. It also takes advantage of the fact that invested assets of older employees will accumulate over a shorter period of time than for younger employees; as a result, a larger current allocation is required for older employees to provide comparable benefits.

As one can see from Exhibit 2, the age-weighted allocation provides a better result for the owners than the pro-rata allocation in Exhibit 1. They receive a larger allocation while the total plan contribution is smaller. However, each owner receives a different amount, as do similarly-paid employees. Although this would also be true in a defined benefit plan, such plan is not an individual account plan and therefore the disparity is not apparent.

The new comparability allocation provides greater flexibility in contribution amounts. It allows each owner to receive the maximum $30,000 allocation--a combined 92% of the total contribution--which is in itself far below the contribution total of any other type. *

PBGC EXTENDS DEADLINES AND RELAXES CERTAIN PENALTIES

By Larry B. Wattenberg, ASA, EA

The Pension Benefit Guaranty Corporation (PBGC) issued final rules on November 7, 1997 with respect to the filing, distribution, and post-distribution certification deadlines associated with standard terminations of single-employer defined benefit plans.

The rules describe the procedures a plan sponsor must undertake to terminate a qualified defined benefit plan as a standard termination (one in which plan assets are sufficient to satisfy all benefit liabilities).

The deadline to file PBGC Form 500 (plan termination notice) has been increased from 120 to 180 days after the proposed termination date. The distribution deadline remains the same at 61 to 240 days after the PBGC receives the plan termination notice. However, if a request for a favorable termination letter from the Internal Revenue Service (IRS) is filed not later than the plan termination notice is submitted to the PBGC, then the distribution deadline is extended to 120 days (formerly 60 days) after the determination letter is issued by the IRS. In addition, the requirement to notify the PBGC of the need for this extension has been eliminated.

Under ERISA, a post-distribution certification is required to be filed with the PBGC no later than 30 days after the date of the final distribution of assets. However, under PBGC's rules, the PBGC will assess a penalty for late filing of a post-distribution certification only to the extent the certification is filed more than 90 days after the distribution deadline. The PBGC has implemented this penalty policy as of March 14, 1997.

To simplify the termination process, the PBGC developed a model notice of intent to terminate that plan administrators may use to inform plan participants of the proposed plan termination. Under the new rule, the notice of plan benefits must inform plan participants of the mortality and interest assumptions that will be used to determine the lump sum distribution.