The IRS recently released the 2020 pension limits. Employee deferrals, catch-up contributions, defined contribution, and defined benefit maximums are all up, giving us a bit more flexibility in plan design. Please visit my website to check out the new (and old) limits.
There’s still time to start a plan for 2019, but we need to get started soon! Contact me, and we’ll talk about your clients’ objectives.
#Pension Limits #Pensions
In an earlier episode of this series, we talked about comparability profit sharing plans. Then in our last episode, we talked about defined benefit plans. Think of the cash balance plan as a hybrid of these two plans. So let’s compare some points of the three plans, in no particular order of importance:
I’ve enjoyed writing the Spring/Summer Series, in part because it reminds me how complex the world of pensions is. You can’t really do justice to it in 500 words on each topic, or at least I can’t. I tried to keep things brief and interesting. I’m always happy to answer any questions, especially those that arise because my writing was too brief. (Or too interesting!) And I’m always happy to provide a proposal for your client. Let’s do some business together!
Next up: related examples of plan design that are not technically part of the Spring/Summer series. Which is good, because Spring/Summer is just about over.
Just a short note between Defined Benefit Plans and Cash Balance Plans, because we have an important deadline coming up.
We talked about safe harbor 401(k) plans, which are very common among small businesses that have a 401(k) plan. They fill a very important need. But new safe harbor 401(k) plans must be adopted by October 1 of their first year. In order to meet that deadline, we need to get started now.
Please contact me if you have clients who may benefit from a safe harbor 401(k) plan.
#401k #Safe Harbor Plans
(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)
I recently rewatched On the Waterfront. It’s a great movie, if a bit dated, that I wanted to share with my sons. They like it enough, but were surprised that it comes in at number 17 in my list of all-time favorite movies. That’s right, I keep a list. I’m not embarrassed to admit it.
Actually, it’s a fairly recent list. Last year, after stating in a blog entry that I have a hard time picking a favorite anything, I decided to try my hand at listing my favorite movies. So I sat down and listed about fifty movies I like a lot. And then I added about fifty more. Then I took off a bunch that I had to admit I no longer really loved. (Those movies either didn’t hold up to time or maybe I just outgrew them, I don’t know.) Then I started numbering the movies, comparing the movies in my head, asking if I liked this movie better than the one above it, etc.
After two weeks (OK, maybe I’m a little embarrassed), I wound up with a list of my top 20. I’m going to spare you the second half and give you the top 10. Anyone who isn’t interested can go to the concession stand for some popcorn.
10. Cool Hand Luke. Great actors, including Paul Newman, George Kennedy, and Harry Dean Stanton. (Mr. Stanton’s last movie, Lucky, is not on my list, but it’s worth seeing just to hear him sing “Volver Volver.”)
9. To Kill a Mockingbird. Every bit as good as the book it came from. I haven’t seen the Broadway play (I’m a little afraid of being disappointed), but I hear that it’s great, too.
8. The In-Laws. Who would have thought that teaming up a CIA agent with a dentist could be so funny? This is one of those movies that gets better every time you see it. But make sure you see the Peter Falk/Alan Arkin version, not the remake. Who would have thought the remake of a great movie could be so not great?
7. The Full Monty. I mean, who among us hasn’t thought about getting a bunch of unemployed mates together and stripping for extra cash? Probably only a few, but somehow the hope and struggles of the characters are very relatable.
6. American Graffiti. I wondered if this wasn’t just a nostalgic favorite from when I was a teenager. But every time it’s on TV I watch a bit, and I always enjoy it.
5. Princess Bride. Here’s another one I can watch over and over. I remember reading the book at my wife’s house when we were dating (it’s OK, she read through quite a few of our dates, too) and loving every page, even those in the lengthy introduction. Read it if you get a chance. Then watch the movie, even if you’ve already seen it.
4. Dog Day Afternoon. Al Pacino is great. John Cazale is great. Chris Sarandon is great. The whole movie is great. Sidney Lumet’s best, and he directed quite a few good ones.
3. Donnie Brasco. By the time I got down to these last three, I was having a hard time deciding. I had to compare them again and again to make sure I got it right. Once again, great acting. Not sure who was better, Al Pacino or Johnny Depp, but the relationship between their two characters makes the movie.
2. The Godfather. For most of my life, I would have considered this to be my favorite movie. I love the entire hospital scene, but hearing Michael say, “Just lie here, Pop. I’ll take care of you now. I’m with you now. I’m with you,” breaks my heart every time. It’s just at that moment that Michael’s fate is sealed.
1. In Bruges. I’m a big fan of Martin McDonough. The first time I saw this, I thought it was brilliant. The second time, I thought it was more brilliant. I don’t know how many times I had to see it before it overtook The Godfather, but it truly has become my favorite. If you’ve never seen it, watch it a couple of times. You won’t regret it.
Well, that’s my list. If you’ve read this far, do me a favor and let me know your own favorite movie. I’m always searching for something good to watch.
It turns out Jane Owner is not thrilled about contributing a large amount to the profit sharing plan for the benefit of John Employee. (See Spring/Summer Series Part 2.) She likes John, she thinks John is a good employee, but she doesn’t want to contribute 16% of pay for him. Go figure.
Fortunately for Jane, we have the age-based profit sharing plan. In a regular profit sharing plan, we look at the contributions as a percentage of pay. In an age-based plan, we look at the benefit the contribution would theoretically provide for the participants at age 65. A participant who is 30 (John) has more years for his contribution to grow than a participant who is 50 (Jane). Therefore, the contribution for Jane would have to be higher than the contribution for John to provide the same benefit. Quite a bit more, as it turns out. Using the age-based allocation and the same $40,000 total contribution, Jane now gets $38,102 and John gets $1,898. This, instead of $32,000 and $8,000 under the regular allocation.
“But what about next year?” asks Jane. “As you know from the census I provided to you, my new employee, Joan Staffworker, who makes $40,000 and is the same age as me (ie, 50) , will be eligible this coming January 1. Will the age-based allocation still work?”
Thank you for that exposition through dialogue, Jane, but sadly, no. That’s why we look to the new comparability profit sharing plan. With this type of allocation, we perform a sort of pension magic (which is to say, a complicated set of actuarial computations) and find that next year, if Jane wants the same level of contribution for herself, she will have to contribute $2,500 for John and $2,000 for Joan. It looks like Jane, with 69% of the total eligible compensation ($200,000/$290,000), is getting 89% of the contribution ($38,102/42,602). Not bad.
You may have noticed that both John and Joan get 5% of pay in our comparability allocation. This is a sort of optimal minimum level, under which Jane’s contribution as a percentage of pay would be limited to three times that of her employees. If John and Joan were to get only 3% of pay, Jane would be limited to 9% of pay. Not horrible, but not as good as our example.
So, what did this part of our Spring/Summer Series teach us? We now know that an age-based profit sharing plan is great when the owner is considerably older than her employees. We know that a comparability profit sharing plan can work well if only some of the employees are considerably younger than the owner. And we learned that exposition through dialogue, though hated by many authors, can be an effective means of conveying information in certain circumstances.
The main disadvantage to an age-based or comparability allocation? The employees are not contributing toward their own retirement benefit.
Next up: 401(k) plans
So, what is a profit sharing plan? The answer is obvious...it’s a plan to share profits, right? WRONG!
(OK, I promise not to do that again.)
Despite its name, making a contribution to a profit sharing plan is not contingent upon the employer’s profit. The reason for the misnomer is that such plans were originally designed to share profits, but that changed over time. Now we’re stuck with the straightforward-seeming name whether we like it or not.
So to answer my own question, a profit sharing plan is a means to provide employees with deferred compensation. In its simplest form, an employer makes a contribution to the plan, and each eligible employee (or participant) shares in that contribution based on the ratio of that participant’s pay to all participants’ pay. For example, 50 year old Jane Owner has a plan with two participants, herself and 30 year old John Employee. Jane’s compensation is $200,000 per year. John’s is $50,000 per year. Any contribution made to the plan will be allocated 80% to Jane and 20% to John. For 2019, the company contributes $40,000, with $32,000 going to Jane’s account and $8,000 going to John’s.
“But wait!” complains Jane. “I already contribute toward my employees’ retirement security in the form of Social Security, at least up to the Taxable Wage Base. Isn’t there some way I can contribute more for those (like myself, for instance) who earn more than the SSTWB?”
Why, yes, Jane, there is. It’s called Permitted Disparity. (In the old days, it used to be called “integrated with Social Security.” Some people still refer to it as such.) With Permitted Disparity, there is an allocation based on all pay, plus another allocation based on pay in excess of the SSTWB. In our example above, Jane would get 5.7% of $67,100 ($200,000 - $132,900), and then the rest would be allocated 80% to Jane and 20% to John. The resulting allocation is $32,765 for Jane and $7,235 for John.
As with all defined contribution plans, what the employee gets out of the plan depends on what goes in on his behalf plus investment growth. Longer term employees, in general, will have more contributions, more investment growth, and higher vesting, resulting in greater retirement security.
Some advantages of a (regular or permitted disparity) profit sharing plan:
Next up: age based and new comparability profit sharing plans.
When I first entered this field, my immediate supervisor gave me a three step approach to learning what I needed to know to take care of qualified plans. First, she had me read relevant IRC Sections along with some of the regulations. (This proved to be very exciting! No, wait, the other thing...mind-numbingly boring.) Next, she handed me a client’s file and said, “Read the plan document.” (Not quite as boring. Far more exciting than watching paint dry.) Finally, she told me to look over what had been done for the client the year before.
All in all, this was an effective way to introduce someone to the world of pensions. It got me started on a rewarding career. But in my Spring / Summer Series, I’m going to do something a little bit different. As I said in my introduction earlier this month, I’m going to give some basic information about different types of qualified plans. (Qualified, meaning they meet the requirements of IRC 401(a).) If it inspires anyone to read the Internal Revenue Code, great! If it inspires anyone to become a pension actuary, even better! And if any of my readers come away with at least a basic understanding of qualified retirement plans, better still!
In my introduction, I said I would break down the series into five parts. I’ve added a sixth. (And who knows, I may add more later! We actuaries a wild and unpredictable bunch!) For this first entry, I’d like to lay out some basic information that’s not specific to any one type of plan, such as:
Eligibility and coverage. Congress recognizes the administrative burden of covering all employees in a plan, no matter how long they work for an employer. For instance, students working during college breaks may be unlikely to come back after graduation, so an employer can legitimately exclude anyone under age 21 from its plan. And employees sometimes don’t work out, either by their own choice or the employer’s. Employers can exclude short-term employees from their plans. Collective bargaining agreements often address retirement benefits for union members. An employer can exclude employees in that category.
Even after excluding employees by statute, an employer may have some category of employees who it does not want to cover. Whether it’s the commissioned sales force, the Third Street office, or Employees Who Never Have Change for the Vending Machine, an employer can choose not to cover some people. But only within reason. And reason, according to Congress and the Internal Revenue Code, means that the ratio of covered Non-Highly Compensated Employees (NHCE) to covered Highly Compensated Employees (HCE) must be at least 70% That is, if your plan covers 100% of the HCE, it must cover 70% of the NHCE. If your plan covers 50% of the HCE, it must cover 35% of the NHCE.
HCE/NHCE. I suppose this is a good time to define Highly Compensated and Non-Highly Compensated Employees. An HCE is an employee who owned 5% of the employer in the current or prior year, or anyone who made over a certain amount (currently $125,000) in the prior year. (The employer can elect to limit those in the second criteria to the top 20% of earners.) An NHCE is anyone who is not an HCE.
Vesting. When we say that a participant’s account balance is vested, we simply means it is non-forfeitable. If an employee leaves an employer for any reason, that employee is entitled to the vested portion of her benefit. When and to what extent an employee becomes vested must be included in the plan document. The three types of vesting are graded, immediate, and cliff. Immediate is exactly what the name implies: an employee is fully vested as soon as he enters the plan. Cliff is similar, in that an employee goes from 0% vested to 100% vested all at once, but not necessarily upon entering the plan. Graded is when an employee becomes fully vested over a period of years, such as 20% after two years of service, 40% after three, all the way up to 100% after six years of service. There are minimum vesting schedules described in the IRC, but any vesting schedule that is at least as good as those can be used in a qualified plan.
Top-Heavy. A Top-Heavy plan is one in which 60% or more of the benefits are for key employees (owners and certain officers). Many, if not most, small plans are Top-Heavy. Being Top-Heavy means that minimum contribution and vesting requirements must be met.
Of course you realize there is much more information I could give, but I don’t want to overload. As we go along, I’m happy to address any questions. Even more, I welcome any feedback. Especially, but not limited to, the good kind.
Next up: Profit sharing plans.
According to a recent poll by CivicScience, Inc, 56% of Americans think that Arabic numerals should not be taught in American schools. 56%. Another 15% polled had no opinion.
Now, I’m not the most mathy mathematician in the world, but I’m kind of a numbers guy. Some dinner table conversations I’ve started with my kids were about whether one infinite set of numbers can be bigger than another (it can) and whether .999... (repeating) is really equal to 1 (it is). Also, I’m part Syrian (my mother’s side), which I guess makes me Arabic myself. So maybe I’m a bit biased in this situation.
The survey of over 3200 Americans asked a simply worded question: Should schools in America teach Arabic numerals as part of their curriculum? It didn’t ask why the responders answered the way they did. Was it bigotry against anything Arabic? Was it because they felt “Hindu-Arabic numerals” is a more appropriate label than “Arabic numerals?” Are they against all concepts of enumeration? We may never know.
Personally, I think the 15% with no opinion simply didn’t remember what number system we use. Not knowing probably has little effect on their lives. The 56% who voted “no” may also not remember. But voting against teaching something when you don’t know what that something is does show some sort of prejudice. I’ll leave it to the experts to decide what that prejudice is.
Me, I would have voted “yes” if they asked me. Learning algebra and trigonometry was hard enough using Arabic numerals. I imagine it would be even harder with Roman numerals.