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April 1994

Beyond age-weighted profit-sharing plans. (Employee Benefit Plans)

by Feller, Benjamin E.

    Abstract- Profit sharing plans are popular among companies of all sizes because they offer contribution flexibility. Since annual contributions may vary from zero to 5% of coverage compensation, the contributions may be reduced or even eliminated when a company encounters financial difficulties. Contribution to a participant's account in a profit-sharing plan is often allocated by making the contribution proportional to pay or by using age-weighted allocation formulas. Alternatives to these allocation formulas were developed based on the principles used to create age-weighted profit sharing plans. One of these is the 'service-weighted' profit-sharing plan which bases contribution on years of service. Another alternative is the 'owner or stock-weighted' profit sharing plan, which normally entails 9% of compensation for each owner/stockholder and 3% for each of the other plan participants.

The allocation of the contribution to a participant's account in a profit-sharing plan is a two-step process. First the employer determines the amount to be contributed to the plan for the year. The second step is to allocate the contribution to each participant's account using an allocation formula. Illustrations of the various allocation formulas are shown in the accompanying table.

Traditional Plans and Age-Weighted Plans

Traditionally, an employer would choose one of two allocation formulas for his or her plan. The first method would be to allocate the contribution in proportion to pay. Thus, if the contribution percentage equaled 10% of pay, then each participant would receive a contribution equal to 10% of his or her pay. The second method would be to use a formula that was integrated with Social Security. Social Security is discriminatory and favors employees with compensation below the Social Security taxable wage base ($60,600 in 1994). This is so because both the company's contribution to Social Security and the Social Security benefit represent a higher percentage of a lower-paid employee's compensation than the percentage for a higher-paid employee.

The IRC and the implementing IRS's regulations permit the company to offset the effect of this discrimination against the higher-paid employees by integrating the plan with Social Security. In the resulting integrated plan, the employer will provide, through combined profit- sharing and Social Security contributions, the same (or more similar) overall percentage-of-pay contributions for higher-compensated and lower-compensated participants. Thus, if a contribution of 10% of pay is made to the plan, then using an "integrated" formula, an owner or executive earning $150,000 a year would receive an allocation of 10.6% of pay or $15,849. This contrasts with an employee earning $30,000 who would receive an allocation of only 7.2% of pay or $2,151.

The next step in the evolution of profit-sharing plans was to create age-weighted allocation formulas. Based on the principle used to fund a defined-benefit plan, a higher allocation percentage can be contributed on behalf of an older participant to compensate for the fact that the contributions made on his behalf will have less years to accumulate investment earnings to retirement than the contributions made for a younger participant.

For example, consider a profit-sharing plan with a normal retirement age of 65 and two participants, one age 55 and the other age 35. the contribution for the 55-year-old participant is based on a funding period of 10 years (65 minus 55), whereas the contribution for the 35- year old is based on a 30-year funding period (65 minus 35). Accordingly, and ignoring interest, the contribution for the 55-year old would be three times (30/10) as great as the contribution for the 35- year old to accumulate to the same amount. By discounting for assumed investment earnings and because of compound interest, the allocation percentage for a 55-year old participant is more than twice as great as that of a 45-year old and is more than five times as great as the allocation percentage of a 35-year old.

Beyond Age-Weighted Plans

Based on the principles used to create age-weighted profit-sharing plans, it is possible to go beyond the age-weighted allocation formula and develop alternatives that better meet the objectives of providing for more senior people. Popular types of prof-it-sharing plans that we have developed include the "service-weighted" profit-sharing plan and the "owner or stock-weighted" profit sharing plan. A typical service- weighted allocation formula would be 1% for each year of service, with a minimum allocation of 3% of pay and a maximum allocation of 11% of compensation. A typical owner or stock-weighted formula would be 9% of compensation for each owner or stockholder and 3% of pay for each of the other participants.

The formula to use depends upon the age and compensation of the participants and, most importantly, on the objectives of the organization.

One advantage of going beyond the age-weighted formula is that it may be possible to equalize the contributions made for two or more owners or executives who are different ages, but receive the same compensation. A better equalization is achieved than by artificially assuming the older participant is the same age as the younger participant, and thus lowering the contribution made on behalf of the older owner or executive, or by increasing the contribution made for the younger owner and all the other participants.

A second advantage of the beyond-age-weighting formulas is that it may be possible to use different allocation formulas for different locations, divisions or businesses of the company. In some cases, it is possible not to contribute for a given location, division or business.

The use of the "age-weighted" and "beyond-age-weighted profit-sharing plans" also avoids paying overly generous benefits to younger, shorter- service employees. In addition, these plans may be used by a company who would like to convert its defined-benefit plan to a less complex profit- sharing plan.

Regulatory and Legislative Considerations

The IRS has issued proposed, final, reproposed, and refinal non- discrimination regulations. Each of these regulations permits the use of the age-weighted and owner-weighted plans, and the IRS is currently issuing favorable determination letters for these types of plans.

During the fall of 1993, the Clinton administration introduced legislation that would have had the effect of prohibiting age-weighted and owner-weighted plans TABULAR DATA OMITTED for plan years beginning after September 30, 1993. For plans that were in existence on this date, the prohibition would be effective for plan years beginning in 1995.

Because this legislation, which is being opposed by the pension community, did not pass Congress, the use of age-weighted and owner- weighted plans is still permitted and continuing. Of course no one knows if this proposed legislation will be reintroduced in 1994, and if reintroduced whether it will become law. Even if it were to become law, it is likely that there will be a grandfather provision permitting the use of age or owner-weighting for a couple of years for plans in existence when the legislation is reintroduced.

Setting Up A Plan

There are two steps involved in setting up a profit-sharing plan, namely, designing and drafting the plan. Once the plan design is agreed to, it is relatively easy for companies that already have an existing profit sharing plan to convert it to an age-weighted plan, a service- weighted plan, an owner-weighted plan or other alternative.

Generally, these types of plans are individually designed to meet the company's objectives. Accordingly, an actuary or consultant familiar with retirement plans and who has the creative abilities needed to design a plan that satisfies the objectives of the company and the IRS's non-discrimination regulations should be used. In addition, the actuary or consultant will have to test the plan each year to make sure that it continues to satisfy the non-discrimination requirements.

Benjamin E. Feller, FSA, is an actuary and President of Pension Review Services, a Long Island, New York pension consulting and pension administration firm.

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