The age-weighted profit sharing plan, a new planning tool for retirement. (Personal Financial Planning)by Langer, David
Example 1. Consider two employees age 60 and age 25 each earning $30,000 and a total company contribution of 10% of salary ($6,000). In a standard allocation, each would receive $3,000. Under the age-weighted profit sharing plan, the allocation could be $5,673 for the older and $327 for the younger--seventeen times as much if the plan is not subject to the "top-heavy" rules, and six times as much if it is ($5,100 and $900).
Example 2. Now assume the older employee earns $150,000, the younger $30,000, and the company again contributes 10% of salary ($18,000). The standard allocation would be $15,000 and $3,000, a five to one ratio. Under the age-weighted profit sharing plan it could be $17,795 for the older and $205 for the younger, or 86 times as much, if the plan is not subject to the top-heavy rules, and 19 times as much if it is ($17,100 and $900).
Service-weighting. Instead of strictly age-weighting a plan, an employer may find it more desirable to reward the longer-service employees by weighting contributions by service, or a combination of age and service, rather than just age. This is a modification of age-weighting, since employees with greater service are more likely to be older in age. Sample allocation formulas that may satisfy the nondiscrimination rules and provide higher contributions in the desired manner, depending on the employee demographics, are shown below:
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The authority to either age-weight or service-weight a plan springs from Reg. Sec. 1.401(a)(4)-8 of the final nondiscrimination regulations published on September 19, 1991, governing IRC Sec. 401(a)(4). The section provides a cross-testing mechanism for determining whether allocations under an age-weighted profit sharing plan are discriminatory. The mechanism basically consists of converting each participant's contribution to a unit of pension benefit at age 65 and then applying the Sec. 1.401(a)(4) general test to that benefit rather than the contribution itself. In Example 2, the contribution converts to a pension benefit of 2.02% of salary for each participant, which meets the general test requirement that the accrual rate for the highly compensated employee earning $150,000 be no greater than the accrual rate for the non-highly compensated employee earning $30,000.
Not Unlike a Profit Sharing Plan
The age-weighted profit sharing plan does not differ in any other respect from the traditional profit sharing plan. Contributions by the employer can be fully discretionary; Social Security integration is possible; the top-heavy and nondiscrimination rules apply; benefits are equal to the account balances; and participant directed investments are permitted. The contribution limitations are also the same: individual allocations are limited by Sec. 415 to the smaller of $30,000 or 25% of salary, and the company contribution is limited to 15% of the total salary of the participants.
Additional Technical Aspects
In making allocations under an age-weighted profit sharing plan, it is necessary to make reallocations whenever any participant's amount exceeds the 25%/$30,000 individual limit. In a plan that is top-heavy-- the key employees' benefit values exceed 60% of the total of the plan as a whole--then a minimum contribution may be required equal to 3% of the salary of each non-highly compensated employee. (The latter may cause a problem if there are young highly compensated employees who are not also key employees.) Finally, general testing under the final Sec. 401(a)(4) regulations needs to be performed annually to demonstrate that the individual contributions, when converted to defined benefit accruals, are nondiscriminatory.
Comparison of Age-weighted and Other Plans
Defined Contribution Plans. The money purchase plan is a defined contribution individual account plan similar to a traditional profit sharing plan, except that up to 25% of the total salary of participants may be contributed and the company's contributions are neither discretionary nor flexible. The target benefit plan is a money purchase plan where the contributions are age-weighted. The target plan has been around a long time, but never really caught on because of the requirement of an annual contribution and the $30,000 maximum.
Defined Benefit Plans. The age-weighted profit sharing plan resembles the defined benefit plan in that the contributions are actuarilly structured. However, there is a world of difference. The defined benefit plan contribution, for instance, is not limited to specified percentages of salary--the limitation is in the annual pension benefit instead ($112,221 per year in 1992). A contribution for a highly compensated older participant can be well in excess of the greater of $30,000 or 25% of salary, and the company contribution in total is not restricted to 15% of total participants' salary. See the accompanying table for comparison of the allocations under the two usual profit sharing plan formulas, the age-weighted formula, and a defined benefit formula.
The age-weighted profit sharing plan will produce a larger contributions for the older employee and do a better job of providing an adequate pension benefit than the standard profit sharing plan. However, the defined benefit plan remains better suited for this purpose, since it can easily relate the pension at retirement to final average pay and total service, and there are no contribution limitations to prevent it from doing so, assuming the necessary funds are available. Where there are older employees, including the owner, who wish to retire, the defined benefit plan can provide an adequate benefit level.
Also, contrary to popular belief, the defined benefit plan can offer contribution flexibility, permitting a certain amount of budgeting by an employer. This usually occurs where there is a past service liability and maximum contributions are made whenever possible, thereby reducing the minimum contribution requirement in succeeding years and expanding the contribution range. This degree of flexibility does not, of course, approach the complete contribution discretion possible under a profit sharing plan, but frequently is satisfactory to the employer.
The defined benefit plan has been saddled with a host of complex requirements generated by the IRS, the Department of Labor, the Pension Benefit Guaranty Corporation, and the FASB. As a result, defined benefit plans are, on average, harder to administer and require greater use of professionals--actuaries and accountants and, from time to TABULAR DATA OMITTED time, attorneys. The administrative cost will usually be higher than for a profit sharing plan, unless the profit sharing plan is encumbered by additional administrative details such as permitting the participant to select investments from several funds, making loans, and frequent distribution of statements to participants. The employer may also need to pay premiums to the PBGC, which are not required of profit sharing plans.
The defined benefit plan therefore requires a higher degree of commitment than does an age-weighted profit sharing plan but, if properly communicated, will usually generate greater goodwill among the older and longer-service employees because of a promised benefit level geared directly to salary and service.
Where the Age-Weighted Profit Sharing Plan is Appropriate
The age-weighted profit sharing plan can be useful for employers that wish to reward older employees with larger allocations, want contribution discretion, and are willing to give up larger contributions (and pension benefits) available under defined benefit plans. The plan may also suit a partnership with older and younger partners where the young partners can only afford a limited amount, while the older partners desire contributions near the maximum level.
Uses may be found for the age-weighted profit sharing plan in combination with other plans. One use is as a supplement to a standard profit sharing plan, a money purchase plan, or a defined benefit plan. Or it may be combined with a Sec. 401(k) plan, which can serve to reduce the amount the employer is required to contribute under the age-weighted formula.
Favoring Those Closest to Retirement
The salient feature of the age-weighted profit sharing plan is the ability to skew the contribution allocation toward the older participants while retaining all the other desirable features of profit sharing plans. This will enable greater retirement benefits for those closest to retirement. However, the new tool IRS made available will not work as effectively as the traditionally defined benefit plan if a larger pension for the older employees is vital.
Employers will find the age-weighted profit sharing plan worth exploring. It also provides an opportunity to take a fresh look at the existing retirement program to determine if it is still suitable in meeting the company's original objectives.
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