The Double-Edged Sword of Plan Design: Cash Balance Plans 2009 ASPPA Annual Conference

1. The Double-Edged Sword of Plan Design: Cash Balance Plans2009 ASPPA Annual Conference Joan Gucciardi Summit Benefit & Actuarial Services, Inc.

2. What Will Be Covered • Objectives that are satisfied by a cash balance plan • Headaches posed by cash balance plans • Designs that can respond to concerns/limitations of these plans • How to help clients make the right decisions • Dealing with clients when problems occur

3. Objectives that May Be Satisfied by a Cash Balance Plan • Desire for additional deductible contributions • Need for increased retirement savings • Age-neutral contributions for employees • Mechanism for partner buy-out • Cost-effective method to track contributions/benefits for business owners

4. Talking Points for Prospective Cash Balance Plan Sponsors

5. Explain the Basics of Defined Benefit Plans • This is a plan which provides a benefit that is determined by the terms of the plan document • The contribution is actuarially determined as the amount necessary to fund the promised benefit • The law does not limit the contribution; rather, it limits the ultimate benefit that can be paid from the plan • The maximum benefit is a life annuity of $195,000 per year, payable at age 62

6. Explain the Basics of Defined Benefit Plans • In order to qualify for this maximum benefit, the participant must have at least 3 consecutive years of earning at least $195,000 • The closer the participant is to retirement age, the larger the contribution because there is a shorter time to fund their benefit • The maximum benefit is decreased for commencement ages lower than 62, and increased for commencement ages later than 65 • It is also reduced if the participant doesn’t have 10 years of participation (or 10 years of service) at the time of commencement

7. Explain who Bears the Investment Risk • In any Defined Benefit plan, because the benefit is guaranteed, the investment risk always lies with the employer • The amount of the participant’s benefit cannot vary based on the performance of the plan assets • If the trust performs better than assumed, the required contribution decreases • If it performs worse than assumed, the required contribution increases over time • There cannot be any participant investment choice – all assets are pooled and trustee-directed: There is no way around this

8. Explain the Disadvantages of Traditional Defined Benefit Plans • Final average pay plans weigh benefits heavily in favor of final years of work • Employees do not relate to or understand or appreciate the accrued benefit shown on their annual statements; e.g. “you are entitled to an accrued benefit of $55 per month at age 62” • Contributions are weighted by age as well as salary – older employees cost more than younger employees who earn the same amount • In the context of small and professional employers, contributions paid do not track directly to benefits paid, requiring eventual adjustments between partners/shareholders when benefits are paid

9. Explain a Cash Balance (CB) Plan • It is a “hybrid” plan in that it is fundamentally a Defined Benefit (DB) plan, but it expresses benefits in the form of a guaranteed account, rather than a guaranteed benefit at retirement • The maximum benefit that can be paid follows the normal rules for Defined Benefit Plans • The plan provides for a fixed annual credit to the account, and a fixed annual interest credit on the account. For example, a plan might say that the annual credit for Shareholders is $100,000, and the annual interest credit is 5.5%

10. Explain a Cash Balance (CB) Plan • Participants receive easily understandable statements showing the value of their account. When they leave, they get paid the vested amount of their account • The actual required contribution differs from the fixed credit because of differences in the actual investment rates and the fixed crediting rates. Who bears the investment risk? The employer • It is not a glorified Profit Sharing Plan: no discretion as to whether to fund it or not and the required amounts are determined under the funding rules

11. Explain the Advantages of Cash Balance Plans • Career average benefit pattern – avoids the heavy weighting of benefits to final years of work • Employees have a much better understanding of their benefits • It allows a direct tracking of contributions to ultimate benefits paid • Age-neutral contributions for employees • A CB plan can be designed to fund a buy-out for partners

12. Explain what Crediting Rate can be Used for the Accounts • The law allows the use of a “market rate” for crediting the accounts – little guidance • We know that rates tied to various treasury indices are acceptable • Can use an index for the crediting rate, the crediting rate can be negative, but then the aggregate value of the annual credits must be protected • If the market rate is negative, the account can decline, but never below the accumulated credits • Sponsors who used the S&P 500 as their index have recently experienced this issue

13. Explain what Crediting Rate can be Used for the Accounts • The use of an index as the market rate for the cash balance accounts will require that the assets be invested in the same index to avoid the contribution discrepancies. • Using an index can result in 415 caps when the index performs very well.

14. Explain what Crediting Rate can be Used for the Accounts • Design your crediting rate for stability and matching it with the appropriate investment –e.g., use the 30 year Treasury bond and invest all the assets in a mutual fund designed specifically to track this rate • Convince clients and the business owners that the CB plan should be the conservative part of their portfolio

15. Crediting Rate Possibility • Set interest crediting rate to • Actual return on plan assets • But no less than zero • And no more than 3rd segment rate • Gains/losses only occur if return is negative or greater than 3rd segment rate • Invest to minimize gains and losses

16. How to Design the Credits • The level of credits must be determined at the sponsor level! • Never poll each shareholder to ask them what level they “want”! • Fit the credits into an objective schedule that satisfies the “similarly situated” requirement. Under this requirement an older employee cannot receive any less of a credit than a similarly situated younger employee • Shareholders must either accept the credit schedule or are excluded from participation.

17. How to Design the Credits • Make shareholders understand that once a benefit is accrued (generally after working 1,000 hours) there is nothing that can be done to avoid funding it. It’s not a Profit Sharing Plan! • Any amendments to reduce the credits must be done before benefits are accrued for that year. It’s not a Profit Sharing Plan! • Instead of the ubiquitous 1,000 hour requirement, consider an accrual requirement of 2000 hours with pro-rata reduction if less, so that if a shareholder terminates employment during the year, there is a partial credit • Consider an accrual of 1/12 for each month that the participant is employed

18. How to Design the Credits: Equal Credits • Equal credits as a flat dollar amount or as a percentage of pay • This approach is often used where the Cash Balance plan “tops–up” an existing PS/(k) plan and the owners want identical contribution levels • No similarly situated employee issue with this approach • Nice and simple because all shareholders get the same amount or percentage

19. How to Design the Credits: Age and Service Bands • Age and service bands-this can accomplish differing objectives within the group – Keep in mind that amendments to the schedule must be infrequent.

20. How to Design the Credits: Maximum Credits • Maximum credits -- Goal is to maximize owners in the Cash Balance plan • Maximus maximus approach – Cash Balance credit for owners is defined as the amount of annual credit that provides a Cash Balance account as of the last day of the Plan year that is equal to the maximum lump sum under Section 415 that can be distributed as of that date • Guarantees that the owners always have a Cash Balance account that is the maximum amount that can be distributed

21. How to Design the Credits: Age Band Approach • Cash Balance credits for owners are defined based on a table • Owner’s age at the time they first enter the plan is based on the age band they are within • Set the amount for each band as the amount that will accumulate to the 415 maximum lump sum at retirement age based on the lowest age in that age band • Use as many or as few age bands as you see fit

22. How to Design the Credits: Age Band Approach

23. How to Design the Credits: Age Band Approach • Important for the owners to understand that their credit is forever determined by their age as of first entry into the plan • They do not move into the higher credit level as they get older! • No possible similarly situated employee issue using this approach • Possible at some point down the road to increase the schedule based on increases in the 415 limit

24. Combined Plan Testing Issues • The CB plan is generally tested with a PS/401(k) plan which provides the Top Heavy minimums • If the plans are top heavy, it is not possible to use an end of year requirement for the PS contribution – anyone who participates in the DB with 1,000 hours must get the 5% TH minimum even if they terminate before year end • The required PS contributions to the NHCEs are not discretionary as long as the CB plan exists

25. Combined Plan Testing Issues • The required DB/DC gateway allocations for NHCEs may not fit in with the PS plan’s allocation provisions • May require corrective amendments under 401(a)(4)-11(g) to deal with – for example an NHCE who terminates with 250 hours gets a SH contribution, which triggers a TH minimum and DB/DC gateway – but the PS plan document says you have to work 1,000 hours to get an allocation • Need a corrective amendment to provide this NHCE with the required gateway amount

26. Combined Plan Testing Issues • The ideal allocation provision for the PS plan to use for this type of combined tested arrangement is individual allocation groups; no hours requirement and no end of year employment requirement! • Shareholders get the flexibility within their PS allocation and 401(k) deferral, because the CB plan is a DB plan and inflexible

27. What Happens when a Shareholder Terminates? • An HCE cannot receive a lump sum distribution unless the plan assets will exceed 110% of the plan liabilities after the distribution • If the assets are not sufficiently funded when a shareholder terminates • Need to leave their money in the plan • Begin taking annuity payments • The firm must prefund contributions so that the 110% threshold will be met • Their payout agreement should be flexible enough to deal with this.

28. What Happens when a Shareholder Terminates? • If a shareholder leaves and the plan is underfunded, and leaves their money in the plan • Remaining shareholders have the risk associated with making the additional contributions to make up the investment losses

29. What Happens When the Plan Terminates? • Always tell clients up front that there are significant fees associated with the eventual plan termination • If the plan is covered by PBGC, the plan can only terminate if the assets are sufficient to cover the aggregate CB account. If not, they can: • Contribute the shortfall; and/or • Majority owners (50% or more) can forego benefits (with spousal consent). • If there are no significant owners (for example four equal shareholders), then there is no one who can waive benefits.

30. What Happens When the Plan Terminates? • If the plan is not covered by PBGC, then all participants can receive benefits to the extent funded by the assets • BUT this potentially exposes the employer and trustees to fiduciary exposure if the participants bring action

31. Murphy’s Laws of Cash Balance Design and Administration

32. Murphy’s Law “I never had a slice of bread,Particularly large and wide,That did not fall upon the floor,And always on the buttered side” [1841, Huron Reflector]

33. Murphy’s Law "If anything can go wrong, it will." "Whatever can go wrong will go wrong, and at the worst possible time, in the worst possible way."

34. Corollary to Murphy’s Law “Whatever you have told your client, they will forget.” It never hurts to confirm your verbal statements in writing.

35. Murphy’s Law Chapter 1 • “I decided not to participate in the Cash Balance Plan this year, as I have some extraordinary expenses” (Translation: I’m buying a vacation home in the Cayman Islands) • Communicate, communicate, communicate • Use the loan program in the 401(k) plan? • Name the participant out of the plan in future years

36. Murphy’s LawChapter 2 “The corrective amounts you recommended give too much to Jane Doe. She left employment two days after the end of the year and I don’t want to give her a penny more than she’s entitled to.” • Compare cost of giving Jane Doe dollars to cost of giving other active employees dollars of corrective amounts • Communication: let sponsor know that corrective amounts may be required from time to time and that you’ll try to find the most economical way to provide them • Provide a greater margin in the initial design of the plan

37. Murphy’s Law: Chapter 3 • “Dr. X is leaving in October of this year (after working 1,000 hours): he wants his money right away and he won’t be contributing to the cash balance plan this year.” • Communicate: “Once you reach the 1,000 hour threshold, you’re locked in for the year.” • Consider designing the plan with a pro-ration for hours worked under 2,000

38. Murphy’s Law: Chapter 3

39. Murphy’s Law: Chapter 4 • “Dr. Y is scaling back and still wants to contribute to the cash balance plan, but can’t contribute as much as before.” • Use a percent-of-pay credit in the cash balance plan (e.g. 50% of pay): Clearly doesn’t work if the Dr. Y’s pay is reduced from $600,000 to $300,000 • Consider designing the plan with a pro-ration for hours worked under 2,000 • Important: can’t use a percent-of-pay credit if pro-ration approach is desired

40. Murphy’s Law: Chapter 4

41. Murphy’s Law: Chapter 5 • “We forgot to tell you that Larry Lawyer, age 31, became a partner this year.” • Initial design: tie the credits to the status of the employee as of the first day of the plan year • If the horse is out of the barn, prepare them for large corrective contributions or consider the use of restructuring where Larry and the other young HCEs are tested with older NHCEs on a contributions basis.

42. Murphy’s Law: Chapter 6 • “I know that we have a defined benefit plan where the contribution is fixed and a profit sharing plan where the contribution is flexible. We don’t want to contribute anything to the profit sharing plan this year.” • Communicate, communicate, communicate • If the top-heavy minimums are being provided in the PS plan, these are mandatory contributions, as well as the gateway requirement • Consider freezing the defined benefit plan: it may be too late to stop the accrual of benefits

43. Murphy’s Law: Chapter 7 • “When you designed the plan initially, we told you that we wanted to keep employees whole and continue to make a profit sharing contribution at the 10% of pay level. We have increased our staff and we now want to reduce that commitment for our staff.” • Back to the drawing board? • If the staff has been increased, but not the HCEs, can the testing support reduced contributions for the newer NHCEs, while keeping the existing NHCEs whole? • Might some of the HCEs want to reduce the level of their profit sharing contributions?

44. Murphy’s Law: Chapter 8 • A CB/DB plan was designed for a medical group • Half of the group members are physician/owners • CB plan covers only physician/owners and easily satisfies 401(a)(26) • The 401(k) plan is a safe harbor where the 3% nonelective only is allocated to NHCEs • After 12/31/08, it is discovered that one of the NHCEs is really an HCE and is not entitled to the 3% contribution. • New HCE is a little cranky because he gets a 7% contribution, rather than a 10% contribution.

45. Murphy’s Law: Chapter 8 • Designing the plan with individual groups would have helped this situation • Using the top-paid group election for HCEs would have also solved the problem

46. Murphy’s Law: Chapter 9 • Freezing the plan generally doesn’t help • October, 2009: client tells you that they aren’t going to be able to afford their contribution for 2009 • Participants have already accrued their full benefit for the year • Under PPA, they need to fund the target normal cost plus the amortization of the shortfall

47. Murphy’s Law: Chapter 9 • Options when freeze won’t reduce the contribution • Consider applying for a funding waiver (approval unlikely) • Freeze the plan anyway: will reduce the 2010 requirement • Borrow the money by 9/15/2010 • Pay the 10% excise tax and get the money into the plan before the IRS finds out and imposes a 100% penalty

48. Murphy’s Law: Chapter 10 • Dr. X retired in January, 2009 • Could not get paid out due to benefit restrictions • Assets are down 30% • Required 2009 contribution attributable to Dr. X: $120,000 • Where to get the dollars from?

49. Murphy’s Law: Chapter 11 • “These plans are just too complicated!” • That’s the price of accelerated retirement savings • If you want simple, maybe a SEP is the appropriate plan • Let’s go back to square one and re-examine your goals • Let’s have an annual meeting to review the plan and make sure it’s working for you and continuing to meet your objectives

50. Questions?