Sponsor News - April 2012
Deferred comp plans: when they're a great choice, and when they're not
Nonqualified deferred compensation plans are a common feature of executive pay packages. They're a great choice in the right conditions, i.e. when:
- The executive's share of company profits is very small, and
- The executive is willing to shoulder the employer's credit risk, and
- Providing the benefits through a qualified plan would be too expensive.
But they're not so great when any of these conditions are missing. Let's examine each in turn.
Small share of company profits: Nonqualified deferred compensation isn't deductible for the company until it becomes taxable for the executive. If the executive is a substantial owner in a profitable enterprise, e.g. a law firm or medical group partner, any deferred income boomerangs right back as taxable profit. In contrast, qualified retirement plan contributions are deductible for the company when they're made, and not taxable to the employee until they're received in cash.
Willing to shoulder the employer's credit risk: Funding vehicles like rabbi trusts can protect the executive from the employer's unwillingness to pay, but not against its inability to pay. In today's economic environment where even large companies are struggling, this risk may be unacceptable. Protection from both of these risks - and even from the executive's personal creditors - is provided by a qualified plan.
Qualified plan too expensive: This is usually the main reason for setting up a deferred compensation plan. Qualified plans have many requirements that don't apply to most nonqualified plans: coverage, nondiscrimination, government filings etc. But they're more flexible than most people realize. In a cross-tested profit sharing/401(k) plan, top executives can often reach the annual $49,000 defined contribution limit with a 5% staff contribution. And if that's not enough, a cash balance or other defined benefit plan can allow much higher deductions: up to an additional $100k-200k per year.
So, are we biased toward qualified plans? Oh, absolutely. Nonqualified plans can be a great choice, but make sure you've maximized your qualified plans first.
IRS Announces Pension Plan Limitations for 2012
According the the IRS website,
- The elective deferral (contribution) limit for employees has increased from $16,500 to $17,000.
- The catch-up contribution limit for those aged 50 and over remains unchanged at $5,500.
- Effective January 1, 2012, the limitation on the annual benefit under a defined benefit plan under section 415(b)(1)(A) is increased from $195,000 to $200,000.
- The limitation for defined contribution plans under Section 415(c)(1)(A) is increased in 2012 from $49,000 to $50,000.
- The annual compensation limit under Sections 401(a)(17), 404(l), 408(k)(3)(C), and 408(k)(6)(D)(ii) is increased from $245,000 to $250,000.
- The dollar limitation under Section 416(i)(1)(A)(i) concerning the definition of key employee in a top-heavy plan is increased from $160,000 to $165,000.
- The limitation used in the definition of highly compensated employee under Section 414(q)(1)(B) is increased from $110,000 to $115,000.
How 401(k) Profit Sharing Helps Small-Business Owners Maximize Their Savings
When the IRS recently announced new initiatives that will increase 401(k) contribution limits, the one that drew the greatest attention was the increase in employee contribution limits from $16,500 to $17,000.
However, there's another change that's just as important for small-business owners looking to maximize their savings while minimizing next year's taxes: it's the annual tax-deferral limit. This is the annual amount any individual employee can contribute and receive into their 401(k) plan in a given year. For 2012, the tax-deferral limit increases from $49,000 to $50,000 (or $55,500 if you are 50 years of age or older).
Employer Contributions Help Grow Your Savings
Employer contributions are what can help some employees, including owners themselves; reach the tax-deferral limit. Most 401(k) plans offer an employer match- which is great incentive for employees to both save as well as stay with their company. It's also an important piece of building towards the tax-deferral limit. Many employers provide a matching contribution of up to three to six percent of an employee's W-2 wages. But that won't get most people near the limit. The key component to do so is Profit Sharing.
The Ins and Outs of 401(k) Profit Sharing Options
An optional feature that any employer can use in maximizing contributions is to share some of the profits into employee 401(k) accounts. Because employer 401(k) contributions, which includes profit sharing, are tax deductible for the business and benefits the owner's 401(k) account too, it's a common practice for many businesses to execute during years they perform well, and not in years the business may have weaker results.
A standard profit sharing plan provides the same percentage of salary contributions to every employee in the firm directly into their 401(k) account. So with a three percent profit share, an employee earning $100,000 would receive an added $3,000 in their 401(k), and one earning $50,000 would receive $1,500. Additionally, the percentage to share can be determined after year-end but prior to the annual tax deadline (typically March 15 for corporations and April 15 for partnerships, sole proprietors and other business structures for those on a calendar fiscal year). This profit sharing component is also popular with the self-employed who can use the profit sharing component with their Individual 401(k).
Advanced Profit Sharing Enables Even More Control
While a standard profit sharing model is the most commonly used in a 401(k), advanced profit sharing is the preferred plan design for businesses with consistently strong profits and fewer than fifty employees. This profit sharing design enables employers to profit share different salary percentages based on unique employee groups within a company.
For example, a legal firm typically has partners, attorneys, as well as support staff that make up the practice. Each group is distinct, has differing compensation levels and is essential to the firm's success. A different percent of salary can be provided as a profit share for each defined group to reward employees based on the group's role, compensation or age. A new comparability analysis is done by the company's 401(k) provider or advisor to determine the optimal levels that best meet the business' compensation objectives. This can be great for the employees and a smart way for the firm to better manage the rewards of sharing profits too.
If you already have a 401(k) plan and think this can benefit your company, talk to your provider about how you can best use the profit sharing feature to meet your business goals. If you're thinking of starting a 401(k) plan for 2011, you can typically purchase a plan until mid-December and you will have until near your tax deadline to make any profit sharing contributions for 2011.
401(k) Retirement Plans Myths - Debunked
National Harbor, MD (October 23, 2011) In Washington, as the super committee looks to slash spending, pension professionals and actuaries gathered in National Harbor, MD for the American Society of Pension Professional and Actuaries (ASPPA) 2011 Annual Conference October 23 - 26. The buzz at the convention was over several proposals in Washington to boost tax revenue by lowering pre-tax limits and deductions in retirement plans. Common myths about retirement plans are leading law makers to propose changes that have the potential to mar the face of the retirement industry and the primary way Americans save for retirement. During the Washington Update session, Brian Graff, Executive Director for ASPPA debunked those myths.
Myth 1 - tax deductions for employer contributions and pre-tax deferrals by employees in 401(k) plans are lost revenue for the government. This is incorrect. Contributions to 401(k) plans are only tax deferred, not tax free. Therefore, the government may generate short term revenue by reducing limits, however, it is a near sighted approach at the expense of American's retirement savings. The government would be paying themselves early and eventually see a decrease in long term revenues. Lower contributions to retirement plans equal smaller investments which see smaller market gains and equal smaller retirement distributions (and taxable amounts).
Myth 2 - less than 50% of American workers are covered by retirement plans. No. The Employees Retirement Income Security Act of 1974 that governs retirement plans was designed for full time workers, not seasonal or part time workers. In March 2011 the results of the National Compensation Survey conducted by the Bureau of Labor showed that 73% of full time American workers have access to a retirement plan and of that amount 80% of them use their plans.
Myth 3 - only the wealthy benefit from retirement plans. Not true, 74% of participants in defined contribution retirement plans (such as 401(k) plans) have family incomes below $100,000 a year. Thirty eight percent of participants earn less than $50,000 a year.
Myth 4 - 401(k) plans are inadequate. There are not enough years of experience to pass judgment. The 401(k) plan was born in 1978 but didn't gain traction until the mid 1980's. In retirement plan years (a lot like dog years), 401(k) plans are only teenagers. These types of plans haven't been around long enough for workers to complete a working lifetime of savings. However, tabulations based on the EBRI/ICI 401(k) Accumulation Projection model show the replacement ratio for 401(k) plans and Social Security combined is over 100% for the lowest income quartile, and well over 80% other income quartiles.
Myth 5 - cuts to limits on retirement plans will only impact the wealthy. Wrong. The government has set forth strict nondiscrimination rules to make sure these plans provide meaningful benefits to all employees. Often times employers must make contributions to these plans for rank and file employees in order to allow highly compensated employees (those making over $110,000) to fully benefit under the plan. If highly compensated individuals (usually owners) are further limited in their benefits under these plans, benefits to rank and file could be reduced or eliminated.
Myth 6 - workers will save for retirement without a workplace retirement plan. Busted. The Employee Benefits Research Institute indicates that participation rates by moderate income workers ($30,000-$50,000) are significantly decreased without a workplace retirement plan. Less than 5% of individuals will save for retirement without a workplace retirement plan. Compared this to over 70% of individuals who will save for their golden years with a workplace retirement plan.
401(k)s: Watch Out For Speed Bumps
401(k) plans at growing companies have some particular pitfalls for CFOs to consider.
The headlines about 401(k) plans vaunt the perils of employers offering employees too few investment choices, or too risky ones, or ones with fees that are too high. But none of those are Chris Beck's problem. Instead, Beck, CFO of BirdDog Solutions, a private-equity-backed logistics provider, is now sifting through a list of the more than 50 investment options that are currently in his company's plan for about 160 employees with $3 million in assets.
As BirdDog has made three acquisitions in Beck's two-and-a-half-year tenure, and merged new employees into its 401(k) plan, "we've tried to be very accommodating by adding a fund here or there," says Beck. That courtesy has now yielded a volume of options he considers overwhelming. "We've got bright people but they're not financial types; people kind of shut down when they have to decide if they want to be in the energy fund, or international emerging markets," or other highly-specific individual investments. As a result, more than half of the plan assets are in the lifestyle and lifecycle funds, effectively prepackaged portfolios that change over time. The task now: "we are going through to find the best of breed in individual funds," says Beck, who is working with advisers, with plans to drop the rest.
Fast-growing companies are particularly prone to having their 401(k) plans get off track in one way or another, say experts. The combination of fluctuating asset levels, executive overload, and Internal Revenue Service rules that are structured in a way to almost ensure closely held companies will violate them means that CFOs at those companies need to keep an especially close watch on them, at least at a high level. "You'd think I'd be most focused on the finance aspect [of the 401(k) plan], but that's secondary," says Gene Lynes, CFO of energy-management consultancy Ecova, which has rapidly grown its plan assets in the past few years to close to $15 million. "Being a good employer, we're trying to protect people for the future and create high morale": no easy task these days.
The move toward fewer 401(k) options is one that has gained a lot of fans from companies both small and large in recent years. J.P. Morgan, for one, recently proposed a winnowing down, or at least an aggregation, of investment options to make things easier for participants. And such screening is a hallmark of plans that are targeted at smaller businesses. At Sharebuilder 401(k) (a division of ING Direct), for example, "our investment committee manages the fund lineup, and takes on the fiduciary responsibility," giving everyone a fairly slim menu of 16 ETFs or one of five model portfolios, says Stuart Robertson, head of the division, which is aimed at plans with 250 employees or less. While there is still some choice and education involved, "we try to make it hard for participants to get off on the wrong foot," he says.
That philosophy is extending to other parts of the plans, as well. Vanguard recently announced a new offering aimed at plans with under $20 million in assets, with standardized record-keeping and administration to help keep fees and hassle low. For example, there's a prototype plan document that plan sponsors are asked to adopt that "has less flexibility than the standard one, but still has everything you need to operate the plan," says Kathy Fuertes, who leads Vanguard's new effort.
Testing 1, 2, 3
While the marketplace for smaller 401(k) plans may be getting richer, the new plans are no panacea for the antidiscrimination test violations that take many CFOs by surprise. Such tests include the actual deferral percentage (ADP) test, the actual contribution percentage (ACP), and the top-heavy test. Their aim is to ensure that highly paid executives and owners of the firm aren't reaping disproportionate benefits relative to rank-and-file employees, so they cap the amount that executives can contribute based on the amount that employees contribute. Violations, even unwitting ones, can wreak havoc on corporate cash flow and executive taxes.
One of the easiest tests to fail is the top-heavy test, which looks at the ratio of the accumulated plan assets of key employees (usually the executive team, and possibly others with ownership) to those of rank-and-file employees, says David Wray, president of Profit Sharing/401(k) Council of America. (He recently blogged about the topic here.) If key employees have more than 60% of the plan's assets, the plan fails.
Many smaller companies "unsuspectingly walk into the experience" of failing, says Wray, because closely held companies with low employee participation and/or high employee turnover will almost certainly fail within several years. "When you first set up the plan, it's not top heavy, but it doesn't take more than four years before it becomes that way," he says. "And it's a dagger into the heart of small companies where cash flow is very uncertain."
The ADP and ACP tests are also easy to fail for rapidly-growing companies, but the problem is not without a solution, notes Joseph S. Adams, an attorney with McDermott, Will & Emery in Chicago. "You can basically buy your way out of the discrimination tests by setting up matching safe harbors," he says.
There are three options to achieve safe-harbor status, and they largely involve employers committing to match at least 3% of employees' contributions, vesting the contributions faster, and in some cases, automatically enrolling employees in the plan, says Adams. A profit-sharing contribution is also an option and protects against all violations, but is typically more expensive. A company can elect to change its safe-harbor status from year to year, but cannot change midyear.
Not surprisingly, many companies elected to drop the safe-harbor status in the depth of the recession, when 401(k) matches were one of the few sources of cash left. Both Ecova's Lynes and BirdDog's Beck say they have run into problems with these tests based on decisions made before their tenures. "Prior to my arrival, the company went through some tough times and had to pull back, which may be why they didn't use a safe harbor," says Lynes. Unfortunately, that resulted in failing one of the tests and executives having to make 401(k) withdrawals, which he says "was a bad scenario," carrying some severe tax consequences for those who were affected. Now Ecova has increased its level of match and changed the vesting time frame to qualify for a safe harbor, a decision Lynes doesn't expect to revisit any time soon.
Beck has a similar story. To resolve issues related to a failed test a few years ago, BirdDog set up automatic enrollment and boosted its matches as required for a safe harbor. "It's better for recruiting and budgeting anyway," says Beck. Now, "we've taken the philosophy that we're committed to the 401(k) plan, and to the extent we run into a blip we'll manage it in ways outside the retirement plan."
All that being said, it's still worthwhile for CFOs to consider the basic task of negotiating on fees as the assets in the company plan grow. "It's very important to renegotiate fees every five years," says Wray. The metric to track is average account balance, rather than total assets, he notes, since that's where profits come from. "The economies of scale here are just so enormous, and the use of technology [makes a big difference]; you should have a lot of leverage."