(I know I promised some 401(k) design examples, but I’m going to put that off until after the Spring/Summer Series.)
In the olden days, before smartphones and Spotify and 401(k) plans, we had rotary phones and transistor radios and defined benefit plans. Used to be if you worked for a company for maybe forty years, they had a going-away cake for you at the office, gave you a gold watch, and sent you off to collect your pension. That pension, with a monthly benefit guaranteed for the rest of your life, was a defined benefit plan. Ah, the good old days.
But enough nostalgia. Defined benefit plans may not be as popular as they once were, but they still have a big place in pension plan design.
A defined benefit plan is exactly what the name says it is: a plan in which the benefit is defined. The terms of the plan tell us what benefit an employee gets when she or he retires. Knowing that, we actuaries can determine what amount must be contributed each year so that, together with investment growth, there will be enough money accumulated for each employee as they retire and collect their pensions for the rest of their lives. In theory. In reality, employees get raises and promotions. They take time off or change jobs. Investments, fickle and uncooperative at times, don’t always do what we expected them to do. On top of all this, the plan can be amended, changing the original benefit into something else. All of which is good for the actuary, who likes to feel needed.
As an example of who might want a defined benefit plan, let’s look at a 52 year old owner with no employees and $120,000 in pay. He could contribute $30,000 to a profit sharing plan, $55,000 to a 401(k) plan, or, based on actuarial determinations, $150,000+ to a defined benefit plan.
You may remember what we said with age-based profit sharing plans, that an older person has fewer years to accumulate a benefit. If the owner above hires a 22 year old assistant, the contribution for that assistant will be significantly lower (as a percentage of pay) than the contribution for the owner.
Defined benefit plans, even more so than the other plans we discussed, are situation specific. We need to look at the employee census to see how well such a plan would work. But when it does work, it can be extremely rewarding for the owner. And when it doesn’t, we can consider a cash balance plan.
Next up: Cash balance plans.
It seems that everyone loves a 401(k). Employers love that the employees contribute to their own retirement security, and employees love them because employers told them to love them.
I’m just kidding, of course. Employees appreciate these plans as they see their account balances grow over the years, they like that they (generally) have control over their investments, and really, they pay more attention because they feel involved. Employee A makes $50,000, contributes $5,000 to her 401(k) plan, and receives a $5,000 match. Employee B makes $45,000, and his employer contributes $10,000 to his profit sharing plan. They both wind up at the same place, but more often than not, it’s the Employees A of the world who understand more about their retirement plan. And this, I believe, explains the huge success of the 401(k) plan.
But I’m a little ahead of myself. First let’s start with what it is: 401(k) is simply the Internal Revenue Code section that allows a Cash or Deferred Arrangement (CODA) in a profit sharing plan. So, a 401(k) plan is a profit sharing plan that has a CODA, and a CODA is just another way of saying “You Can Take Your Money Now Or You Can Put It In The Plan And Take It Later.” (CODA is much easier than YCTYMNOYCPIITPATIL, isn’t it?)
Now we have a profit sharing plan with two types of allowable contributions: an employer profit sharing (non-elective) contribution and an employee (elective) contribution. But with the employee elective contribution comes a new type of employer contribution, the employer match. The match is a function of what the employee puts in. An employer might, for example, match 50% of what the employee contributes, but not more than 4% of pay. Or the match could be 100% of the employee’s contribution, but not more than 3% of pay. Employers usually put in that second clause to make sure their obligation is not open ended.
One easy-to-predict problem with 401(k) plans is that higher earners are more likely to contribute to such a plan. This is fine for the high earners, but as government policy, the purpose of the 401(k) is to encourage savings among all levels of employees. To address this, there are certain nondiscrimination tests to make sure a plan reaches everyone, effectively limiting what the average Highly Compensated Employee (HCE) contributes in relation to what the average Non-Highly Compensated Employee (NHCE) puts in. And this works well, and for quite a few years everyone was happy. Well, not everyone. Small business owners with even a moderate amount of turnover never knew if their plan would pass the nondiscrimination tests from year to year. In a plan with only a few participants, the termination of one HCE or one NHCE could change the test results dramatically. And so the safe harbor 401(k) plan was invented! Under the safe harbor, a plan is deemed to pass nondiscrimination tests if either a minimum match or a minimum non-elective contribution is offered, regardless of whether the NHCE contribute anything at all.
To recap and expand just a little, a 401(k) plan is a profit sharing plan with employee contributions, plus an employer match, an employer non-elective contribution, both, or neither. (Admittedly, “neither” is rare, but possible.) The match is contingent on the employee contribution, and the non-elective contribution can be allocated in any acceptable way, depending on the employer’s objectives. (Remember, we talked about a straight percentage of pay, Permitted Disparity, age-based, and comparability allocations.) Most 401(k) plans allow the participants to choose their own investments (within the confines of the plan’s options), but that’s not actually a requirement.
I could go on (there’s so much to cover!), but we’ll stop here before everyone gets bored. (Am I being too optimistic?)
Next up: examples of 401(k) designs.
#Spring/Summer Series #401(k)