By Dr. James M. Dahle, WCI Founder
The single best tax break available to physicians is maximizing your retirement plan contributions. Most self-employed or partnered doctors already have a defined contribution/profit-sharing plan (SEP-IRA or 401K) available to them into which they can contribute $58K a year for 2021 ($64,500 if they're 50+.) If your federal and state marginal income tax rate is 37%, you just knocked $21,460 off your tax bill. But what if you want to save MORE of your money toward retirement? You can use a backdoor Roth IRA or even a taxable account, but neither of those reduces your tax bill this year. One option you should consider is using a special kind of defined benefit plan called a cash balance plan.
Two Broad Categories of Retirement Plans
Retirement plans can be divided into two broad categories.
#1 Defined Contribution
A 401(k) is an example of a defined contribution plan, where you contribute a certain amount each year. Depending on investment returns, that initial contribution may grow to be a small amount, a large amount, or even disappear completely. There is no guaranteed benefit at the end. All that is defined is how much you can put into it as you go along. The amount of money you will have to spend in retirement depends entirely on how much you put into the account and the performance of your selected investments. The risk is all on you.
#2 Defined Benefit
A defined benefit retirement plan works differently. The classic example is the increasingly rare company pension. You work for a company or government entity for 20 or 30 years, and after you retire, the company pays you a defined benefit for the rest of your life. The company takes all the investment risk. If the investments do well, the company can get away with putting less money into the account. If the investments do poorly, the company must contribute more to the account. But either way, there is no difference to you. You get the defined benefit.
Cash Balance Plans Are a Hybrid
A cash balance plan is technically a type of defined benefit plan, but it can act like a defined contribution plan in two important ways:
- Depending on how your plan is designed, you can actually change how much you can contribute each year (or if you want to keep your plan administrator happy, every few years) to the plan.
- Upon separation from the employer, or when the plan is closed for any reason acceptable to the IRS, you can transfer the money tax-free into a 401(k) or IRA, just like a 401(k) or most other defined contribution plans.
For most participants, the cash balance plan is essentially an extra retirement plan allowing for additional tax-deferred retirement contributions above and beyond those allowed in the 401(k). Perhaps the best way to think of a cash balance plan is that it is an additional 401(k) masquerading as a pension. It has to follow the actuarial rules that apply to pensions, but at the end of the day, (wink wink nod nod) we all know you're just going to roll it over into your 401(k) in five or ten years.
When private companies were trying to get rid of their expensive pension plans, many of them converted their pension plans into defined contribution plans, transferring the investment risk from the employer to the employee and often lowering the cost to the employer (and the benefit to the employee). However, some companies simply changed their pension plan into a cash balance plan. Employees didn't like this any more than seeing a 401(k) replace their pension, but this concept of a cash balance plan does provide an additional tax-sheltering retirement plan option for a physician or other high income professional.
How Cash Balance Plans Work
A cash balance plan seems complicated because, as a defined benefit plan, it must at least resemble a typical pension. That means the participants in the plan generally select or manage investments in the plan, at least not in the frenetic way that many frequent traders “invest”. The cash balance plan requires complicated actuarial calculations to determine the maximum contributions that can be made into the plan for any given employee. The contributions also must technically come from the employer, not the employee. Due to these complications, fees on a cash balance plan are generally higher than those in a 401(k). Unless you are an independent contractor with no employees (and maybe not even then), this type of plan is not a do-it-yourself project; you will need to hire an experienced company to design and run the plan. Our WCI Recommended Retirement Plan Advisors are pros at doing this and can customize the best plan for your business.
Contributions to the Plan
All contributions into the plan are generally pooled and invested together by the plan trustee. However, hypothetical individual accounts are tracked and credited with a certain amount of interest each year, depending on the performance of the underlying investments.
If the investments perform well, that credited interest rate may be higher up to a certain point, such as 5–7 percent per year. If the investments perform very well, the additional earnings, above and beyond the 5–7 percent limit, are allocated to a surplus account where they can be used to make up for future shortfalls in investment performance or to reduce future required contributions. If the investments perform poorly, the owners of the company may be required to contribute additional money to the plan to make up the losses over a period of a few years.
This aspect of defined contribution plans turns off many physicians (who are generally not only the participants in the plan but also the owners of the company). However, in reality, this mechanism is of significant benefit to the physician. In a market downturn, not only do you GET TO (also admittedly HAVE TO) defer even more money into the plan, but the make-up contributions are also deductible. You are essentially forced to buy low, boosting future market returns. In essence, the company is taking the investment risk, not you. Of course, for many doctors, you are the company, so you're taking it either way.
Example #1: Predetermined Interest Plans
For example, in my old cash balance plan, it worked like this. The money was invested across 8 mutual funds, in a 54%/46% stock/bond ratio. Each year an investment committee (made up predominantly of physicians in the plan) decided how much interest to credit the participants. In the event the investments had little to no return, participants didn't get an interest payment. In the event of a high return, the interest was capped at 6.5% and the rest went into the reserve account. If the return was negative, money was pulled from the reserve account. In the event of a really low return, the company (ie, the physician partners) had to make an extra contribution to the account to make up some of the losses.
While that sucks to have to do in an economic downturn, especially when you'd rather be buying low yourself in your personal accounts, at least by doing so the plan is buying low, which should improve future returns. When you retire or leave the company, you did not get any share of that reserve account even if there had been recent high returns in the plan, but nor were you required to make an extra contribution if the plan has a significant loss the year you separate from the company or partnership.
Under this arrangement, how much more could you have to contribute in the event of a severe market downturn? In 2008 my plan lost 22.8%. First, the reserve account was applied, reducing the net loss to about 15%. By law, that loss is spread over 5 years, so it is divided by 5. The “company” (i.e. the partners in the plan) had to make their regular annual contribution, plus 3% of what they had in their “individual account” in the plan at the beginning of 2008. So if you started 2008 with $100K in the account, and your annual contribution was $10K, the contribution due at the end of 2008 was $10K + 3%*$100K, or $13K. Of course, that entire $13K is tax-deductible. There was also a much smaller contribution due in 2009, but investment gains then put the plan back into a surplus.
Example #2: Plans That Credit with Actual Returns
Some newer cash balance plans credit your account with the ACTUAL RETURNS of the underlying investment(s). My partnership has had three cash balance plans while I have been there. The first one worked as described above. The most recent one essentially allowed me to choose between three Vanguard Life Strategy Funds (Moderate-60/40, Conservative-40/60, and Income 20/80) as far as how much risk I wanted to take in the plan. (If you care, I chose the most aggressive one because it was closest to my overall asset allocation, knowing that I could potentially have to put additional money into the plan in a downturn.) In this case, if the fund makes 12%, I'm credited with 12%. If it loses money, I lose money.
There are lots of options in how the CBP actually works; you should discuss all of them with your retirement plan professional when implementing a new plan and read the paperwork carefully (and ask questions) if you join a practice that already has one in place.
As in a 401K, the money grows in a tax-deferred manner, and you can't access it before age 59 1/2, except for some limited circumstances, without paying a 10% penalty (plus the taxes due).
When you retire or separate from the company, you can either annuitize your “account balance” or you can take it as a lump sum, either in cash or by rolling it over into an IRA or another retirement plan.
How Much Can You Contribute to a Cash Balance Plan?
This is, unfortunately, a really complicated question. The answer depends on how much is in there already and how old you are. It can range from just a few thousand to over $300,000. There's a law that only lets you accumulate up to “an annual benefit” of ~$2.9 Million (2020) into the cash balance plan. So the older you are, and the less you have in there, the more you can contribute. Additionally, the annuitized benefit cannot exceed either the average of your top three years of consecutive compensation or $230,000 (2020), whichever is lower. See what I mean about not being a do-it-yourself project?
In general, you contribute either a percentage of salary or a flat sum (such as $5,000 or $40,000) each year. Of course, if you have employees, non-discrimination testing must be done and you may have to contribute 5-7.5% of their salary for each of them. Many plans, due to actuarial restrictions and top-heavy testing, limit you to much lower contribution limits than what is theoretically possible. My contribution limits have ranged from $15,000 to $30,000 in my plan, but some older members of my partnership can currently contribute as much as $120,000 per year.
Watch Expenses
Expenses for cash balance plans can be considerably higher than for a 401K plan, because they require an actuary to get involved. For example, one of the plans I had charged 0.2% for the 401(k) and 0.6% for the Cash Balance Plan.
What Are the Downsides to Cash Balance Plans?
It's possible the investments perform poorly for a long period of time and you have to make up the interest payments out of your cash flow. That doesn't seem like a big deal if you have to make up a 5% payment on a $50,000 balance ($2500), but coming up with $50K could be a huge issue if you have a $1 Million balance. If you're not already saving $58K (2021) into a 401K (and probably maxing out backdoor Roths for you and your spouse), then you're unlikely to benefit from a cash balance plan especially given the decreased flexibility and higher expenses which drag on returns. The average physician (making $275K) probably doesn't need one of these plans simply because they don’t make enough money to really benefit from them.
Although the money in the plan technically belongs to the company, not you, the assets must be managed for your benefit and are not subject to the company's creditors. They are also generally protected from your creditors. The pension is also usually insured by the Pension Benefit Guaranty Corporation, a government entity. Your company generally pays $35 per year per participant for this insurance, but may be exempt if there are fewer than 25 employees.
Also, if you're required to make significant contributions for your employees, this can be an additional practice expense, eliminating the personal benefit to you, the owner.
Cash Balance Plans Are a Good Option for Partnerships
Many physicians and dentists incorporate both a 401(k)/profit-sharing plan and a cash balance plan into their practices. Despite the additional expense, the immense tax break available, as well as the asset protection (generally fully protected from creditors, just like a 401K) make them particularly attractive. The flexibility available through the plans is also a huge benefit. Partners can make different contributions, the plan can often be made physician/dentist-only, liability between partners can be managed, and you can scale back on contributions or even amend or terminate the plan relatively easily if cash flows decrease.
Independent contractors without employees can also use this combination of accounts. An individual 401(k) is relatively easy to set up. A personal defined benefit plan is a little more complicated but still widely available from a number of firms at a fair cost. Because you are both the trustee and the participant, you will have even more control over your investments.
Advanced Thoughts
There are two other considerations to keep in mind. If your business qualifies for the 199A deduction, remember the cash balance plan contribution counts as a business expense. That means it will lower your ordinary business income and potentially, your 199A deduction. Of course, it is also possible that this deduction actually brings your taxable income down into the range where you now qualify for the 199A deduction. I wish it wasn't that complicated, but unfortunately it is, at least for a few more years until the 199A deduction expires.
Also, if you are a super saver, you may wish to preferentially use tax-free contributions such as Backdoor Roth IRAs, Roth 401(k)s, Mega Backdoor Roth IRA contributions to a 401(k), Roth Conversions, and Health Savings Account contributions instead of making additional tax-deferred savings like a defined benefit plan. This is one reason WCI, LLC doesn't have a Cash Balance Plan. Naturally, you can later convert these dollars to a Roth IRA, but that may not be worth it to you. There are not a lot of these doctors out there (for example, only 8% of my physician partners maxed out their DBP when it had a $30K/year contribution limit) but this audience includes a lot of them.
Bottom Line on Cash Balance Defined Benefit Plans
Cash balance plans are an additional 401(k) masquerading as a pension. Physicians interested in boosting retirement savings and minimizing their annual tax bill should give strong consideration to adding a cash balance plan on top of their existing 401(k) plan. A cash balance plan is a great option for those who wish to save for retirement and are already maxing out their 401(k)s and backdoor Roth IRAs.
What do you think? Do you have a cash balance plan? How does yours work? What is the maximum contribution? Are you making it each year? Why or why not? What percentage of your group is maxing it out? Comment below!
There are three major disadvantages of a defined benefit plan such as this:
1. You are required to contribute to them. Unlike your defined contribution plan such as a 401k, you must contribute yearly to this. Thus if you have a bad year and wanted to forgoe a contribution, you really cant do that with this. While you can terminate such a plan (ususally rolling over the money into a defined contribution or ira), if you dont keep the plan for at least 5 years, the IRS seems to take notice and might fine you/disallow the previous deductions.
2. If you have a bunch of employees then it is more costly bc you will need to make payments on their behalf. Sometimes this helps you keep good employees, sometimes they would just prefer more cash in hand.
3. It is more expensive to administer. My plan costs about 2k per year just to administer not including any transaction fees. I personally dont have any AUM fees bc i manange it myself. Schwab seems to have the cheapest of these plans and i think their yearly fee is around $750.
A defined benefit plan also affects how much you can contribute to a defined contribution plan. In my situation, im now limited to around 32k per year for the employee/empolyer combined contribution.
In the end, these are best for physicians who are either older, dont plan on working a long time, and have few employees. Avoid any person who tries to get you into a 412i or 412e plan. These plans have the highest deductions but you get the same defined benefit so in the end you just pay more for the same retirement benefit.
1. True, but the required contribution can be set quite low. It’s $2250 a year for the plan I’m in with the option to put in up to $15K.
2. I don’t believe this is necessarily true. I believe if nothing else you can put employees in a different class than owners and thus contribute little to their “accounts.” Here’s a link to an example where the owner gets to put in $60K but only has to put in $2K for the staff.
3. For sure. I’m not too familiar with a 412i, but according to this both 412i and 412e are insurance based pension plans, thus mixing insurance and investing, which is usually a bad (and expensive) idea.
1. Yes but if you set the required contribution to be low (by reducing the defined benefit), then the costs of these plans make it such that there arent a good idea. This is one of the reasons why it is better when you are older, you are allowed a larger contribution/deduction in order to obtain the defined benefit.
2. While there are ways to reduce amounts for other employees, there are limits to this and the more employees you have, the more it adds up.
3. The reason i bring this up, is that whenever one is talking about any type of DB plan, it is important to focus on the benefit and not the contribution. Since most of us here about these as ways to reduce taxes, we mistakenly think that more is better. What if i said, i could put you in a DB plan, that even more reduces your tax burden by allowing you to contribute more than 3 times what you are currently contributing and its all tax deductible. At first thought, you might think that sounds great but thats bc you might mistakenly think that by contributing more that you will get more benefit later on when you retire. This isnt the case. With all DB plans the benefit is set to a certain number up to the current max of 200k per year. No matter how much you contribute, you will never get more than that thus what you really want is to contribute the least (in a realestic manner). Sure you will need to pay more taxes but you will still get the same benefit in the end and have more money in your pocket at the moment.
As an additional sidebar, if one has both a DB plan and a DC plan and they have a mix of conservative and aggressive investments (but not too aggressive such as index funds as aggressive and bonds as non aggressive), then one might want to put the conservative into the DB plan. This assumes that over the long haul the aggressive does better. If you are a serious gambler and like buying a bunch of individual stocks then you might do the reverse since when you actually figure out that you cant pick stocks, you will be allowed to contribute more to the DB plan to maintain the same defined benefit.
Also, the ability to put different employees into different classes for both db and dc profit sharing plans is limited largely by the ages of the different groups. If the physician partners are older and the support employees younger this works great. However, if the partners scew young, and the employees older, then you get very little benefit from grouping.
While this plan can be good, it’s best for the investors to realize the huge difference between retirement planning and investing. The key to a successful retirement planning is to diversify your investments to places where you can preserve your money and at the same time make some on top of the investments. Click here to learn how hybrid income annuity works.
The most popular of these hybrid income annuities are equity-indexed annuities, and they are generally products made to be sold, not bought. They have many disadvantages when compared to a cash balance plan, including the loss of the valuable up-front tax deduction.
WC u are being generous. The above is nothing better than spam. Annuities are typically a horrible idea as an investment.
One thing I should mention is that if taxes do rise, you may wish to consider just putting in the minimum funding this year with the idea of a larger deduction next year after taxes rise. Of course this assumes taxes rise.
My 5 physician group was planning on enrolling into a CBP. I was disappointed with Medamerica as they were not replying to my emails. Anyone else have suggestion regarding any other providers with low expense ratio/fees?
I’m hoping to have another guest post soon from a doc who is trying to get one set up.
Yes, email this man
Gregory Springer
[email protected]
https://www.beonretirement.com
They literally just set one up for me les than 10d ago. Both Cash and 401 plans
I’m currently setting up a plan for my group with 50 physicians. We are an anesthesia group, and only have a dozen other employees so we are very top heavy. This kind of group is ideal for a cash balance plan. We contacted Vanguard and they put us in touch with an actuarial group that sets these things up. We have spoken to a few different administrators and it will cost between 11k and 18k a year to administer the plan. We intend to use the short term bond index as our benchmark, and will invest in the matching Vanguard fund to minimize the chance we have a shortfall at the end of the year. Different classes will be setup. $5000 will be the low, and we will likely do a couple of other tiers, maybe $50k and $100k. You have to meet PBGC guidelines, so your Administrator will tell you how much you can contribute.
So this was the fee proposed by Medamerica for our 5 physician group. We do not have any other employes- I think the fee is pretty steep for a 5 person group. What do you guys think?
401k VALUE FEE (Billed directly to each fund or self directed account)
.40% on the market value of the account (taken directly from the plan)
401k PARTICIPANT CHARGES (Billed to each group quarterly)
$6 per participant per month
DEFINED BENEFIT VALUE FEE (Billed directly to plan and subject to minimum)
.60% on market value of the account (on first $2,000,000 of assets)
.40% on market value thereafter
Minimum Annual Fee for either a single or combined plan:
Additional Fees:
MEETINGS IN EXCESS of ONE TRIP PER YEAR
Does not include initial enrollment meetings
$500 per day plus expenses
401k Participant Loan Setup (paid by individual)
PLAN DESIGN / ACCOUNT SET UP FEES
$10,000 *
(includes plan design, IRS filing fees, Schwab account set up fees, employee meetings
for both a 401(k) and defined benefit plan and other ancillary costs)
Pension Benefit Guaranty Corp. (“PBGC”) Premiums paid by Defined Benefit Plan
TERMINATION FEES
401(k) SELF DIRECTED CHARGES (paid by individual only if option is utilized)
VALUE FEE
$200 annual charge per account (billed annually by Schwab in January) on balances
up to $500,000, $500 on accounts with balances over $500,000.
TRANSACTION FEES
Subject to the standard charges as published by Chas. Schwab & Co. (Schwab.com)
Internet trades
$12,000 annually
$50
$5,000 within first two years
Waived thereafter
$8.95 per trade
That’s very similar to what our group pays MedAmerica (spread out among a lot more docs). What seems steep to you? The initial fees or the ongoing? I’d be interested to hear if you find someone doing it for significantly less.
Well I am not familiar with the prevailing rates for setting up the account, so I thought the rates were high. Guess the rates are competitive. We are planning to get quote from another vendor too. Will update you if anything works out cheaper.
There are flat fee administrators in the marketplace. One is Verisight (Pension Specialists). They charge a base annual fee and an additional per participant fee …. no percentage of assets under management fee.
Oncdoc: These fees are way too high. Also, don’t forget mutual fund fees, which can be as high as 1.5%. Total administrative expense for the TPAs I work with are around $5,500 for the CB plan and $1,500 for the 401k plan. Startup cost is about $5,000 at most. You should not have to pay any AUM fees aside from low cost index fund expense ratio of around 0.2% on average. The biggest concern for CB plans is managing your portfolio adequately to minimize volatility and minimizing your fiduciary liability in case your employees sue you, and both of these can be addressed by a retirement plan consultant who is an independent fiduciary working in your best interest to find the best/lowest cost solution for your business (and who is not compensated by third parties to sell products or plans).
RC has the right idea about how to manage CB portfolio, but you need to be very careful. The problem with using short term bond index is that you won’t get close to the 4% rate that is expected from the plan, and you might have to put more money in down the line. The effect of a lower rate compounds, and after a while it can get costly. I’d recommend working with a good actuary who can explain the implications of lower crediting rate.
Sleepy: I think you are referring to administrative expenses charged by a TPA. Some firms offer both investment management and administrative services, and some make money from selling higher cost mutual funds without providing any investment management services. In all cases, any services other than administrative are compensated by AUM fees. I don’t know of anybody who manages portfolios and does not charge AUM. When dealing with a Cash Balance plan, the entire trick is to manage the plan investments properly, as not doing so can be costly for the plan sponsor in many different ways.
RPC, The entity I referenced does have a very small fee based on AUM … 0.05% ($750 minimum). The point …. there are “low cost” providers in the CBP marketplace.
James: The 0.05% AUM fee you are referring to is a custodian fee, this is where the money is actually located. This is a typical charge for low cost custodians (Schwab, Ameritrade, etc). There are many low cost TPAs – I always recommend that plan sponsors work with low cost TPAs. However, this is only part of the solution.
Did you know that any plan participant can sue the plan sponsor for breach of fiduciary duty for such things as higher than average fees, losses in their accounts and many other things, and that you as a plan sponsor will be financially responsible for any damages? Some plan sponsors use more expensive funds to pay for plan administrative expenses, and this too can be a breach of fiduciary duty. There is a reason why ERISA attorneys make sure that plans offered by bigger (and more expensive) providers conform to the latest laws and regulations. I’ve seen plenty of times when a ‘do it yourself’ plan sponsors try to cut corners and save a penny by doing everything themselves, or by doing nothing at all. The good old days are gone – welcome to the era of liability and damages (as of 2008). If your plan does not offer the right level of services, you might as well not offer a plan at all because your employees won’t see any reason to be happy with their match when they routinely lose money in their plan due to fees, poor investment choices, or (most likely) because they have no idea what they are doing and a ‘seminar’ they get once a year that passes for investment education is a waste of time (and everyone knows it).
If you have a solo plan, you have nothing to worry about (except poor investment performance). If, on the other hand, you have any employees at all, (or if you have a much more complex plan such as Cash Balance or Defined Benefit) saving a penny on necessary services will cost you a dollar later, one way or another. If you pay more to go to a ‘full service’ provider, you (sometimes, if your plan is large enough) get the right level of services, but the cost can be much higher for such a plan. So this is a very important trade-off to consider – how can a plan sponsor get a low cost plan with all the necessary services for a price that is much lower than offered by full-service providers?
RPC, You are correct that the 0.05% AUM is the custodial fee. There is NO additional fees except for the internal ER of the chosen funds. The 0.6% AUM fee can be eliminated by using a “low cost” CBP provider.
I recently established a cash balance pension plan and am getting ready to fund it. My financial advisor has recommended that the plan invest in fixed index annuities that would have minimum return of 5%. Normally, I wouldn’t personally consider this product as an investment due to its high fees and complex nature, but it may be an appropriate investment for a cash balance plan. Any thoughts on this would be very helpful.
I think that your gut reaction is correct. Fixed index annuities I’ve seen do not have a minimum guaranteed return of 5% (at least not the ones I’ve seen).
A Cash Balance plan investment has to be fairly conservative, and having fixed income as an investment is a good idea. I would be very careful with using insurance products inside your Cash Balance plan though because of complexity, high fees, and very uncertain returns (in the case of index annuities). Having an all-bond portfolio might be more appropriate, will cost you less in fees, and it will be much more transparent. Depending on your horizon, your portfolio inside your Cash Balance plan has to be designed specifically for your financial situation, so surrender penalties and the like might be a problem for index annuities for early withdrawals. Also, depending on whether you have employees, index annuities might also cause early withdrawal problems.
Is your broker compensated directly by you (that is, fee-only), or are they compensated for selling products? If they are not a fiduciary, then anything they recommend might not be good for you (it will be good for the broker though).
It is always a good idea to hire a fiduciary to provide investment advice to your plan. Presumably you also have a 401k plan. The adviser has to be at least a 3(38) fiduciary:
http://litovskymanagement.com/2014/01/hiring-fiduciary-adviser
And it goes without saying that your adviser has to understand the tradeoffs on how to construct portfolios inside your Cash Balance plan given that you also have a 401k plan, so your overall allocation has to be considered, not just your Cash Balance plan allocation.
Sure, if they’re going to guarantee you a 5% return it sounds pretty good. Unfortunately, I have yet to see a fixed index annuity guaranteeing that return.
The problem is that the brochures are written in such a way as to seem or appear (insert your legal language here) that there MIGHT be a 5% return given a particular set of assumptions about the stock market, but given the contracts I’ve seen (and I’ve been looking at index annuities recently), the highest number I’ve seen is about 2% ‘guaranteed’. You can get a lower rated 5-year annuity and get something closer to 3%. But again, this is most likely an inappropriate product for a Cash Balance plan.
All of these plans are a waste of time and fees. Pay the tax now, put the money in a taxable account, and invest in index funds.
This is not entirely true for everyone. There is a breakeven point, and after expenses and matching contributions retirement plans can help you put away anywhere from 20%-30% more towards retirement pre-tax even if the proceeds are taxed afterwards. I’ve developed an analysis to estimate the breakeven point for after-tax and pre-tax investing, as well as to evaluate whether a particular retirement plan design will beat the afer-tax approach. So with the right retirement plan you can have 1/3 more money when you retire. That’s not too bad, wouldn’t you agree?
I disagree. The ability to get an upfront tax deduction (deferring taxes for decades), tax-protected growth, a tax rate arbitrage upon withdrawal, and ongoing asset protection is extremely valuable. I max my plan out every year.It is low cost, has reasonable investments, and is reasonably well-managed.
WCI, you said your plan charges 0.6% of plan assets per year, in addition to the expense ratios on the funds used in the investments (which range from 0.07% to 1.26%). To me these fees seem high–and all this for an annualized return of somewhere between 0-6.5%. Don’t you think one can do better by paying the taxes now and investing in a low-cost equity index fund?
For example, check out this calculator. The pre-populated values are way off base, but if you put in more realistic numbers, the taxable account beats this plan in almost every scenario. Of course this could just be my personal situation, but I invite others to try it.
After-tax will not be a good choice for everyone. If your tax rate is high, even with employee contributions it is worth doing a retirement plan for your practice.
The plans we work with typically have no asset based fees, and an average investment costs from 0.1% – 0.2% (low cost index funds). No need to have a plan with high fees and bad investment choices.
I typically do a personalized analysis to see whether a retirement plan would be worth it vs. after-tax because each situation is different, and one can not have a blanket statement saying that after-tax is better because of high fees (which can be avoided and eliminated with the right plan design and providers).
The actual expenses are about 0.4% right now, I believe, but the plan is closing this year and I’ll roll the last 3 years of contributions into my TSP with expenses of 0.02%. So no, I don’t think I can do better. If you run the numbers, you’ll see that you need expenses of 2%+ before NOT using an employer provided plan is a better option, especially if you’ll be separating soon.
Why did your plan close? Was that unexpected or concerning to you?
No, it allowed us to move the money into a lower-cost, higher control 401(k). It’s a good thing for sure. Plus we’re starting up a better one.
Everything you mentioned is true, but there is a breakeven point, and some plan designs/types might not be worth it depending on your particular situation. For example, if you have many older employees, a Cash Balance plan might cost too much for the owner to justify vs. after-tax. So it does depend on individual circumstances. Also, someone in CA and NY might get more out of a retirement plan (given higher income and capital gains taxes) vs. someone in Tx (with no state tax and no state capital gains tax). Even better would be retiring in a lower tax state.
If you live in a high tax state, you end up in the AMT. We would need to make over 800k a year to escape the the AMT 28% marginal rate to the 39.6% top rate. NJ taxes everything, deferred comp, cash balance, etc. The only thing that isn’t taxed is the 17.5k that goes into a 401k. I’ll take all the income I can get at a 28% tax rate and have it in a taxable account. If an investment opportunity appears, or I need the money, it’s not locked away in an account I can’t touch. There is too much risk hoping that my retirement account doesn’t get ‘redistributed’ to the 99% because there is too much in it, or that taxes don’t go up. The bottom rate is 15% now, 28% is only 13% higher. Risk/benefit doesn’t make any sense to me, granted if you are in a low tax state and can save closer to 50% on taxes, it makes more sense.
I agree that there is a chance that the government might go after retirement plans. However, it can also go after your after-tax money as well. All they need to do is to crank up the short/long term capital gains rate and the income tax rates. S&P500 index pays anywhere from 2% to 3% (long term average of 2.5%) in dividends, which are taxed as qualified dividends, but if you were to diversify globally and to invest into a foreign indices, that 2.5% dividend would be taxed as income (unqualified dividends) on as much as 50% of your dividends. And if you were to balance your portfolio with bonds, you’ll also pay income taxes on the interest. This effect would compound (especially if you are in a high tax rate state) so this will cost you money in the long term (I estimate that this might cost as much as 12% in 25 years, depending on your asset allocation).
It is always a good idea to diversify widely, including between taxable and pre-tax accounts. Like you said, the flexibility is extremely important, so it makes sense to max out pre-tax accounts if possible, but most docs make plenty of money to do that and to invest after-tax. In fact, unless a Cash Balance plan works out for you (it might never work out for some types of practices), there isn’t much you can do as far as increasing your pre-tax investments, so you’d have no choice but invest after tax.
The choice of investments also has to be carefully examined – individual municipal bonds make a lot of sense (especially in high tax states).
I’m not sure why you’re such a fan of individual munis when there are low cost muni funds available from Vanguard. States and cities are not the federal government and there is real benefit to diversification in that asset class.
There are multiple reasons, actually. Maybe I should do a post on that because there are pros and cons to individual munis. I’ve seen an article that flatly said to avoid individual munis altogether (for reasons I don’t necessarily buy), yet I’ve also read others who say that one should avoid muni bond funds. I’ve got my own personal reasons though, one of them being that I can get a higher yield with individual munis, and I have the ability to design customized portfolios (which is important, because you can do some good planning with munis). One reason against muni bond funds is loss of principal. I consider this ‘safe’ money, so I don’t want to take any more risks than necessary with it.
Higher yield comes with higher risk; that’s not necessarily a good thing. The “loss of principal” argument against bond funds is bogus. Your individual bonds lose value just like the individual bonds in the bond fund, whether you actually calculate it or not. Even as good as you may be at buying and selling individual bonds, there’s no way you’re getting as good a deal as a Vanguard bond fund, plus you’re running a lot more credit risk since you can’t diversify as widely. I’ve seen people debate the individual bonds vs bond fund many times, and it seems reasonable for someone buying treasuries to opt for individual bonds. But municipalities can’t print money like the federal government. Not only is it a lot of hassle, but you end up with something worse in the end. If you really want to submit a post on the subject, it would make a good Pro/Con series.
Looking at a CB Plan for a Radiology group actuarial fees are $6k per year 22 employees mostly young and 8 doctors plus 1 Director…. There is no AUM or any other fees paid other then the $6k per year for the actuary but the investment product going to be used is a variable index annuity where there will be downside protection to losses covered to a certain percent (depending on which surrender and index you use) which gets locked in when you chose your index. The surrender is 1-5 year and you can get upside for example on the russell 2000 of 6.2% (on the 1 year surrender) do you think this is a smart move?
there will be fees associated with the variable annuity but all the money will be invest upfront. here is the website of the annuity if you wanted to check it out to see what I am saying. http://www.axa-equitable.com/microsite/scs/
Hi Mary,
I’m talking about fees that are paid to those who sell the annuity by the company. So they sell it to you and get paid for selling, and they also have a residual in addition to an upfront commission.
If you trust your adviser (if you even have an adviser who works for you in your best interest), then you should trust them on everything they tell you. If you are posting here wondering whether this is the right product for your plan, then you probably have doubts about what your adviser is telling you. Based on what I know about this product (and believe me, I’ve done the analysis for my clients) index annuities may not be the right product for your plan, and actual performance of such annuities (including this one) is highly suspect based on historical data showing that using bonds will provide better returns, but I’m not your adviser, so I can only offer my opinion.
Given the size of your plan, and the potential to contribute a lot of money, what you might want to do is hire the right adviser who can create the right portfolio and/or find the right product (while not being compensated by third parties for doing so). Your adviser would be able to compare various products side by side and to prove to you that one is better than the other based on data and/or other considerations, and offer an unbiased, uncorrupted opinion on which products will be the best for your plan. Other than that, you will have to trust your current adviser and his/her motivation in recommending this product for your plan.
Good luck
The available data on equity-indexed annuities shows very disappointing returns. An advisor recently emailed me the data from one of his clients who had bought, comparing it to an S&P 500 Index Fund and a broadly diversified DFA Fund:
Purchase Date Equity Index Annuity Total Return S&P 500 Index Fund Total Return DFQTX Total Return
7/25/2005 16.2% 90.2% 104.7%
3/28/2006 18.8% 78.1% 86.13%
5/15/2007 11.8% 49.9% 60.01%
9/26/2007 15.9% 48.8% 60.61%
5/12/2009 8.9% 138.9% 159.77%
6/4/2010 -9.2% 92.7% 100.02%
Pretty dramatic, no?
Hi Mary,
Variable or equity index annuity has fees that are not disclosed and it is a product that is sold (and for a good reason, because it is easy to sell). Something that is ‘free’ can not possibly cost nothing, so you pay for it somehow, in this case, thorough underperformance. This is a very complex product and the return on it will not be as good as what it is sold to be – one will never get the full upside, and the formula for what you will actually get is rather complex. Here are some actual historical studies of how index annuities performed.
Here’s a study on equity-linked annuities written for and by financial advisers:
http://www.onefpa.org/journal/Pages/Real-World%20Index%20Annuity%20Returns.aspx
Here’s more analysis of index annuity returns:
http://annuityoutlookmagazine.com/2013/01/index-annuity-returns-backwards-forward/?goback=.gde_4228652_member_239283751
http://annuitygator.com/average-real-returns-of-fixed-indexed-annuities/
It is the conclusion of several highly qualified researchers that bonds are a better choice vs. index annuities. Loss protection is something that comes at a huge price, and going forward, your plan will pay for that with poor performance. The company has to be compensated somehow, and you can be sure that they are getting a paid handsomely for this product.
We typically use bond index funds for Cash Balance plans. Depending on the goals of the plan, individual bonds (Treasuries/corporate) can also be a good choice. The key here is to realize that the best advice you’ll get on your plan investments will be coming from fiduciaries who act in your best interest, not from product salespeople whose job it is to sell products (and who will tell you half-truths about their products). Many products haven’t even been around long enough to have historical returns, so ‘hypothetical’ illustrations are basically half-truths.
Thanks for some great input everyone. So the biggest thing with the Index annuity above all is the probability of underperformance do to fee’s associated with the annuity? Our target return is 5% every year. I understand the higher compensation associated with the annuity, but if we are targeting 5% every year and anything below 5% the company will have to kick in additionally. Isn’t downside protection and limiting the upside good because with higher upside we loose on next year contributions and then next years tax write offs and downside we have to add an extra expense not already planned for??
I don’t see any reason to use an index annuity in your cash balance plan. If you’d like downside protection by limiting your upside, then use a less aggressive asset allocation in the cash balance plan.
Do you know anybody (who really understands how an index annuity works) who recommends using them AND doesn’t sell them? I don’t.
but then don’t we hurt our chances of getting 5%? Because I’m assuming you mean using more bonds in the allocation? Aren’t bonds pretty risky also due to probability of raising inflation?
The risk of bonds is far less than the risk of stocks, even with “the probability of raising inflation” whatever that means. If you can predict the future, then invest in something that will do well in the future. If your crystal ball, like mine, is cloudy, then diversify. Nobody knows what is going to happen with inflation or interest rates over the next 1-20 years.
Here’s how I would put it. Suppose inflation rises. If you own individual bonds, it is easy to build a portfolio that resets quickly so that any interest rate increases will not hurt your return. With a bond mutual fund it is more difficult to do, but still doable. All you have to do is make sure that you are not overexposed to bonds that can be disproportionally hurt by the rise in interest rates. This effect (losses due to interest rate jump), however, will be tiny compared to the losses you can experience from stocks, as White Coat Investor says.
There is another issue that I came out, which I think is important. Maybe in the old days there were investments that could crank out 5% every year. Heck, even a money market was able to do that a while back. Nowadays, that’s not the case. It is possible to set the rate of return to be the rate of return on your balanced portfolio and/or a specific investment. As long as you are getting a return that allows your plan to pay the minimum level of benefit to your employees (whatever that rate is), and that return can be an average over a long time (not just several years). This way you avoid the whole issue of trying to meet a specific rate of return, which might be difficult if your portfolio contains stocks, so your annual return can overshoot and undershoot. This is a relatively new way of tracking return, but I think it is a better way than trying to clear a specific hurdle, as long as the long term return can beat, say, 5%.
Hi Mary,
There are a lot of assumptions here, so let’s take a closer look.
“So the biggest thing with the Index annuity above all is the probability of underperformance do to fee’s associated with the annuity?”
The underperformance comes from the fact that index annuity does not deliver returns appreciably higher than bonds. This has to do with the fact that this product is designed to make money for the insurance companies, so naturally they will get the difference between what they pay you and what they invest your money to get a better/higher return. The question is, how do they invest money to get a better/higher return so that you don’t have to use such an inferior product?
“Our target return is 5% every year. I understand the higher compensation associated with the annuity, but if we are targeting 5% every year and anything below 5% the company will have to kick in additionally.”
Target return does not mean that you have to get 5% every year. It means that on average (depending on how your actuaries set up the plan) your return has to be 5%. If you underperform or outperform year to year within some margin, you are still fine, so you don’t have to hit the 5% every year. Some years will be under, and some years will be over. If you are too much over, or too much under, that will cause problems, so the portfolio has to be set up to be very low volatility so that you don’t have to worry about that. The problem with an index annuity is that you can actually significantly underperform the 5% on average.
“Isn’t downside protection and limiting the upside good because with higher upside we loose on next year contributions and then next years tax write offs and downside we have to add an extra expense not already planned for??”
See above – you might get a 2% annualized return over 5+ years, making this a terrible product. There is no upside here, just a product that might not beat a regular 5-year CD yielding 2% and/or a regular fixed annuity yielding 2.5%. A balanced portfolio might get you 5% on average over a decade with some volatility (again, depending on how it is designed).
“but then don’t we hurt our chances of getting 5%? Because I’m assuming you mean using more bonds in the allocation? Aren’t bonds pretty risky also due to probability of raising inflation?”
Stocks are risky, bonds are risky, index annuities are risky (because they can seriously underperform). The key here is to design a balanced portfolio to target a 5% average return. That’s what a good adviser can do for you. When designing portfolios, all factors have to be taken into account, such as rising inflation (or deflation), stock market crashes, your practice turnover (what if someone has to take their money sooner, who will pay surrender charges?). There are many factors to consider here, so a portfolio will have to be designed to take all of this into account. It will be a passive portfolio, but it will have to be actively managed (for example, to take care of distributions). I wish there was an off-the-shelf product that magically worked, but index annuity is not it. You will pay a lot more for it in various ways than you will pay to hire a good investment manager for your Cash Balance plan.
Thanks again everyone for your help you really helped me understand more with CB plans and investment options!!!
If you need an independent fiduciary adviser to assist with your Cash Balance plan investment selection and management, I’m always available.
http://litovskymanagement.com/2014/01/hiring-fiduciary-adviser
As a partner in CEP America & a participant in the DB plan, thank you for this explanation of how it works. Despite multiple readings of the plan document, I never quite understood it until now.
Thank you for this entire website as well. I recommend it and your book to anyone that will listen to me.
They’re a bit complex. We’re actually closing our plan and opening a new one with various changes at the end of this year.
Now be sure to write or update us about the new plan and why you switched. I’d be interested to know as we are about to enter into this realm as well. (7 Doc private practice….)
Depends on who is asking. If it’s the IRS, we’ve got a good reason. If it’s anyone else, it’s to get the money out of the plan into our 401(k) or IRAs. 🙂 The new plan does have some nice upgrades though. The old plan limited us to a return of 0-6.5%. The new plan will basically just pay us what we earn. I’ll write something more in depth when I get the formal paperwork. The downside to closing it out was significant legal, accounting, and actuarial costs.
Thanks so much WCI!
Question: If people roll this old DB plan into an IRA, does that screw up their future ability to do a back door Roth IRA? Assuming they dont have the scratch to roth convert it all.
Also, what is the purpose of rolling into a 401k or IRA? Better returns/lower expenses?
That’s why you might want to roll into another 401k if possible. So if you have any 1099 income, that’s a perfect opportunity to open a solo 401k, even if the income is not much, and roll the DB plan into the solo 401k (with an appropriately drafted custom plan document that allows incoming contributions and in-plan Roth conversions).
Yes, if you have a traditional IRA, then you will not be able to do backdoor Roth conversions tax-free. You will be able to convert parts of the IRA to Roth though and pay the taxes. You can also do Roth salary deferrals into another retirement plan too. So there are many ways to go about this.
Hey Kon, thanks for info.
I do have some 1099 income, though it is quite small, $1,000. I might could beef that up some with greater effort. How much 1099 income would I need to open a solo 401k to have a landing spot for my DB plan? (A landing spot other than my IRA because I don’t want to screw up my backdoor Roth IRA.)
That’s plenty enough. Just make sure you realize that Vanguard’s solo 401k does not allow incoming rollovers, so you’ll either have to go to another brokerage or get a custom plan document and open a VRIP account at Vanguard.
$1.
Yes, an IRA screws up the backdoor Roth.
Yes, better investing options, more control, lower expenses.
By the way, having a crediting rate equal to an investment performance might be ok if the portfolio is a low volatility portfolio vs. what’s traditionally used. I find that most CB portfolios are extremely risky and this creates big problems down the line (for those planning to retire shortly and for younger doctors). Either the return is too high (which means you can’t contribute as much as you could if the return was closer to 4%-5%, which means less years of contribution for younger doctors) or the return is very low (especially during crashes), which is a bad deal for those who retire during crashes. Either way, starting with a portfolio that’s designed based on retirement age and account balance (something along the lines of ‘liability matching’) is a better idea than traditional 70:30 that I see is used by many CB plans. And there should not be any asset-based fees in CB plans, period – at most a 0.15% cost of Vanguard funds. But AUM fees are still bread and butter so good luck getting mainstream providers on board with that one.
interesting…. noted and waiting for this poit!
Cash Balance plans are rather complex. The problem is that most vendors are very opaque about how they work, and for a good reason. For some reason, I find that most will not tell you that you can easily max this plan out within 10 years and you won’t be able to ever contribute to a CB or a DB plan again!
I spent some time not long ago with a great actuary who showed me the ropes of how the math works for these plans, especially how to set up a plan for various types of scenarios. Sometimes it is OK to set up a plan to end in 10 years, and sometimes you might need a plan that includes a bunch of younger doctors who might want to contribute over several decades if possible.
There is also the CB/401k pairing, and various types of investment decisions that have to be made. For example, many plan sponsors use a huge amount of risky funds inside CB plans with is a big mistake given the market volatility (that can result in under/over funding) and the fact that higher returns might actually max out their plan contributions too fast!
There are also various types of design of paired plans that might produce better results for certain scenarios. For example, having a front loaded plan or a back loaded plan might work better than a level design, but all of this analysis has to be done. The difference can be quite significant, too, and I’m yet to see anybody do a proper illustration and scenario analysis given how much money will be contributed to these plans!
Some of the big vendors cut corners all the time, and they might hire an actuary to do the design, but the actuary almost never communicates with the plan sponsors about it, and the salespeople do not know much about how the math works.
So before getting a CB plan paired with a 401k, you better know for sure whether a front loaded, a level or a back loaded design will be a better approach for your specific practice, and have the vendors do the analysis (or hire someone who can show you how the numbers work!), otherwise you might be getting a suboptimal design that leaves significant money on the table.