Cash-Balance Pension Plans

An Opportunity to Maximize Retirement Planning Strategies and Reduce Taxes

The 2008 financial crisis and resulting recession had a devastating effect on the financial health and retirement plans of many small business owners and small to medium-sized professional groups. Over the past few years, business owners have worked hard to rebuild. Now, with recovery in sight, the American Taxpayer Relief Act of 2012 (ATRA) creates new challenges for highincome taxpayers.

Higher income tax brackets at the federal level, reduced itemized phaseouts on deductions, and surcharges on net investment income and earned income will subject high-income individuals and families to even higher combined marginal tax rates. For business owners and professional groups, cash-balance pension plans might present an opportunity to maximize or catch up on their retirement-planning strategies, reduce taxable income, and take advantage of asset and creditor protection.

What is a Cash-Balance Plan?

Considered to be hybrids, cash-balance pension plans are a type of retirement plan that offers the unique characteristics of traditional defined-benefit plans, with annual contributions and promised retirement benefits, and the individual account features and portability of defined-contribution plans. Two major differences between a traditional defined-benefit plan and a cashbalance plan exist.

First, under a traditional defined-benefit plan, an employee receives upon retirement a specific benefit that is defined as an annuity or a series of monthly payments for life; under a cash-balance plan, on the other hand, the employee benefit is tie value of the employee's account. This can be turned into an annuity, taken as a lump-sum distribution, or rolled over into an individual retirement account (IRA) or other type of qualified account.

Second, under a traditional defined-benefit plan, the amount that must be funded annually into the plan is based upon the retirement benefit promised to each participant, irrespective of investment returns for the plan. If the investment returns for the plan do not meet the actuarial rate of return needed to meet the retirement benefit, it creates an unfunded liability for the employer. In a cash-balance plan, the employer makes contributions based upon a hypothetical pay credit (either a percentage of annual compensation or a fixed dollar amount) and a hypothetical interest credit rate (ICR). The ICR can be set annually to match the market's return (or the plan's actual investment return), eliminating the potential for an unfunded liability. Although cash-balance pension plans were created in 1985, they have gained momentum since the 1RS provided clarity regarding the ICR in late 2010.

How Cash-Balance Plans Work

First, a hypothetical account is set up for each employee in the plan. On an annual basis, the employer makes a contribution into each employee's account. This amount can differ by employee, and not all employees need to participate in the plan; however, the plan must comply with cer- tain 1RS rules and regulations. The hypothetical account balance for each employee is adjusted annually, based upon the ICR used. The 1RS now allows the ICR to be equal to the plan's actual rate of return, as long as the plan's investments are adequately diversified; therefore, the value of the plan's assets is always equal to its account balances. Employee balances vest after three years.

Example. Consider a closely held organization with four owners and 16 employees, shown in the Exhibit. The owners each earn $255,000 and contribute the maximum amount to their existing 401(k) defined-contribution plan. The owners seek to 1) maximize their annual contributions for retirement savings, 2) reduce their taxable income, 3) provide additional asset and creditor protection, and 4) remove the potential that market volatility will create an asset-to-liability mismatch or unfunded pension liability. As demonstrated in the Exhibit, the owners are able to contribute an additional $652,000 annually to their employer contributions after implementing a cash-balance plan. The additional cost of providing this plan to their 16 employees is only $27,525 ($81,525 in revised discretionary contributions and new employer contributions, less an original employer discretionary contribution of $54,000). In addition, the owners have created tremendous tax savings because their contributions reduce their taxable take-home pay dollar for dollar.

Companies Best Suited for Cash-Balance Plans

The following companies are best suited for this type of retirement plan:

* Businesses that have consistent cash flow and are highly profitable. Pension plans require annual contributions, so companies should have a demonstrated pattern of profitability.

* Business owners seeking to either maximize or catch up on their retirement savings. Because contributions are agedependent, they can be as high as $250,000 per year, based upon the design of the plan. But not all participants are equal-a plan can be designed to maximize the benefit to the owners, while minimizing contributions to other employees.

* Business owners seeking to reduce their taxable income. Contributions into qualified plans reduce taxable income dollar for dollar. With higher marginal tax rates taking effect, the impact on owners' taxable income could be significant; however, 1RS mies limit the maximum lump-sum accumulation to approximately $2.5 million per participant.

* Business owners seeking asset and creditor protection. Because cash-balance plans are protected under the Employee Retirement Income Security Act of 1974 (ERISA), they represent the perfect vehicle for entrepreneurs, doctors, lawyers, and other professionals who seek asset and creditor protection. As with all pension plans, they can be guaranteed by the Pension Benefit Guaranty Corporation for a nominal fee.

Additional Considerations

Cash-balance plans have other valuable benefits as well. They can aid business owners in the recruitment and retention of executives as part of their benefit package. Furthermore, these plans can be used for succession planning in family-owned or closely held businesses. Because all qualified retirement plans are subject to myriad regulatory issues, it is worth tie cost to engage a qualified third-party actuary to ensure a successful plan.

The ATRA increased the tax obligation for most high-income individuals. Many anticipate that additional taxes and reduced deductions will be necessary in order to help reduce the U.S. deficit. A cash-balance pension plan can represent an opportunity for those who had previously overlooked one.

Richard Gotterer, CFP, is managing director and senior financial advisor of Wescott Financial Advisory Group LLC, with offices in Boca Raton and Miami, Fla.; Philadelphia, Penn.; and San Francisco, Calif. He can be reached at rgotterer@ wescott.com.