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Does a defined benefit plan make sense for me? Any experience with this?

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  • White.Beard.Doc White.Beard.Doc 
    Participant
    Status: Physician
    Posts: 937
    Joined: 02/06/2016

    I am the sole owner of a business.  The business is very generous with contributions to our safe harbor/401k/profit sharing plan for all employees.  The non-highly compensated employees get a 3% safe harbor contribution and a 3% employer paid contribution.  They also get a cash bonus.  The highly compensated employees get 6% employer paid contributions plus generous annual cash bonuses.

     

    A pension consultant tells me that I should add a defined benefit combination plan for myself as the owner.  They are recommending the following:

    1. Increase contributions for NHCEs to 7.5% from the current 6% (3+3) which will pass all fairness testing rules and in turn allow all kinds of flexibility for the HCEs and the business owner.  The money for this extra 1.5% could come from a small reduction in the cash bonuses or be paid as additional compensation.

    2. Reduce the employer paid contribution to the HCEs a bit, but allow the HCEs to contribute additional amounts (up to very large amounts) from their own elective salary deferrals in a very flexible and individualized manner.  The HCEs will be able to save so much tax with these more flexible and larger deferrals that they will come out way ahead at no cost to the employer because of their enhanced tax savings. (We are located in a very high tax state.) . The employer will save a bit by continuing to make generous contributions, but a bit less than before because of the other benefits to HCE employees.

    3. Add a combination defined benefit plan only for me as the sole owner, and fund it with contributions over the next several years (3-10 years).  When fully funded, dissolve the plan and roll it over to my 401k.

     

    My questions:

    1. Does adding this defined benefit combination plan sound like it makes sense?  I have lots of extra income that I am currently putting into taxable accounts because I can only contribute 62k/year to tax deferred with the current plan setup.

    2. Can I end up with too much in tax deferred accounts?  Would having too much in tax deferred potentially lead to more estate taxes, when in contrast paying the tax now and having less in taxable accounts (relatively equivalent post tax value but higher current balance in a tax deferred account where the taxes would be owed upon withdrawal) potentially keep us under the estate tax limits (whatever they may be when the second one of us dies sometime off in the future)?

    3. What type of investments are appropriate for a defined benefit plan?  The pension consultant said that relatively modest yield, safe and stable investments work well during the funding phase of a defined benefit plan.  The investments can then be further diversified once the plan is dissolved and rolled over to my 401k.

    4. Should there be life insurance in the plan?  (One of the referral sources who connected us with the pension consultant for this plan works for an insurance company and recommended life insurance to cover potential estate taxes.)

    4. The asset manager of the defined benefit plan is compensated by an AUM fee.  Is this typical or are there other fee structures for defined benefit plans?

     

    This all seems somewhat complex to me with lots of moving parts.  Thanks in advance for any advice…..

    #240789 Reply
    Avatar jacoavlu 
    Moderator
    Status: Physician, Small Business Owner
    Posts: 2381
    Joined: 03/01/2018

    Design should give you figures for a percentage of total assets going into the plan that go to you, total percent going to NHCEs, total percent going to HCEs. Obviously from your perspective the greater percent going to you the better.

    DBP certainly does not require a manager getting an AUM fee. That could be a very hefty fee. I’d demand a flat fee, or even handle it myself, especially if the great majority of funds in the DBP pool are yours anyway.

    The Finance Buff's solo 401k contribution spreadsheet: https://goo.gl/6cZKVA

    #240807 Reply
    Molar Mechanic Molar Mechanic 
    Participant
    Status: Dentist, Small Business Owner
    Posts: 400
    Joined: 10/29/2017

    Lots to chew on there that I cannot help with.

     

    DB plan has been great for me.  If my biggest problem in 20 years is too much in pre tax dollars, then I’m ok.  My plan was already in place when I became a partner, so I didn’t have a voice in its design or implementation.

     

    Our plan was initially with an advisor who changed a fee to assign the assets in a 60/40 allocation in highish fee funds, while using a separate TPA.  When I got involved, we kept the TPA but moved the assets into a custodial account with vanguard.  Vanguard simply holds the funds.  Since we have a pooled fund, we agreed to put it into 100% VBIAX, which is Vanguards 60/40 fund.

     

    Both of of our wives are employees of the practice, and both are HCE, which allows them a significant DB plan contribution as well.

    #240825 Reply
    Hank Hank 
    Moderator
    Status: Attorney
    Posts: 1404
    Joined: 03/27/2017

    You might be decent candidate for a defined benefit plan at work.  The tax savings can be substantial.  No need to pay an asset under management fee instead of a moderate fixed annual fee (paid by your business as a necessary expense and not reducing money put into the DB plan).

    Fund the DB plan aggressively early.  Be able to add more money if the market severely contracts and your actuary and third party administrator say you need to kick in more money.

    I wasn’t terribly impressed with the stable value funds that were the default position for our defined benefit plan.  Like Molar Mechanic, we went with Vanguard balanced (VBIAX).  We have contributed far, far more than the minimum required by our employee census for the last few years.  In the unlikely event that we’re called upon to kick in a good chunk more cash to keep the actuary and the Department of Labor happy, we almost certainly will be buying at fire-sale prices.

     

     

    #240831 Reply
    White.Beard.Doc White.Beard.Doc 
    Participant
    Status: Physician
    Posts: 937
    Joined: 02/06/2016

    One of the reasons that this business has been extremely successful is generosity to the employees, contributing to hard working, happy staff and low turnover.

    This outside pension plan consultant slaps his forehead and shakes his head when he sees our current plan’s design with generous early vesting, our generous contributions to all employees both HCE and non-HCE, and the fact that the owner has not designed the plan for maximum personal benefit, but rather for great benefit to all employees.

    It seems like a new combination plan along with slightly higher contributions for non-HCE’s would allow the business to continue to be generous with all of the employees, a core philosophy of the company and a primary goal.  It would also allow all of the HCEs the optional flexibility to defer very large sums which is not an option with the current plan design, up to their entire compensation. (Is that correct? It sounds a bit crazy, but that is what the consultant said to us, giving the example of a 300k employee married to an even more highly compensated spouse.)

    And finally, it will allow the owner to save 46% in income taxes on additional contributions over time, allowed in the defined benefit plan, significant savings in taxes.

    It seems like our next best step is to consult with additional pension experts to learn more before making a decision.  But it would also be good to get this started in 2019 for the substantial tax savings that are available this year.

    #240923 Reply
    Liked by Hank, q-school
    White.Beard.Doc White.Beard.Doc 
    Participant
    Status: Physician
    Posts: 937
    Joined: 02/06/2016

    Design should give you figures for a percentage of total assets going into the plan that go to you, total percent going to NHCEs, total percent going to HCEs. Obviously from your perspective the greater percent going to you the better.

    DBP certainly does not require a manager getting an AUM fee. That could be a very hefty fee. I’d demand a flat fee, or even handle it myself, especially if the great majority of funds in the DBP pool are yours anyway.

    Click to expand…

    Thanks!  It sounds like management of the funds in a DBP can be managed with various fee structures, including self managed. That information is very helpful.

    #240924 Reply
    White.Beard.Doc White.Beard.Doc 
    Participant
    Status: Physician
    Posts: 937
    Joined: 02/06/2016

    Lots to chew on there that I cannot help with.

     

    DB plan has been great for me.  If my biggest problem in 20 years is too much in pre tax dollars, then I’m ok.  My plan was already in place when I became a partner, so I didn’t have a voice in its design or implementation.

     

    Our plan was initially with an advisor who changed a fee to assign the assets in a 60/40 allocation in highish fee funds, while using a separate TPA.  When I got involved, we kept the TPA but moved the assets into a custodial account with vanguard.  Vanguard simply holds the funds.  Since we have a pooled fund, we agreed to put it into 100% VBIAX, which is Vanguards 60/40 fund.

     

    Both of of our wives are employees of the practice, and both are HCE, which allows them a significant DB plan contribution as well.

    Click to expand…

    Yes, of course there are worse problems than too much in tax deferred, but when you have a long career earning more than you need and factor in potential longevity, the projected numbers start getting quite large with the tax deferred. Who knows what estate tax rates will be in the future, but if we pay lots of taxes now and invest in taxable rather than tax-deferred, that could lead to avoidance of future estate taxes. Estate tax exemptions are very likely to change, so its merely a guessing game.

    As far as low cost pension plans, in the past we switched over our safe harbor/401k/profit sharing plan from a low cost to a very low cost record keeper holding vanguard funds.  It sounds like I could self direct a defined benefit plan with vanguard funds as well to keep fees as low as possible.

    #240925 Reply
    White.Beard.Doc White.Beard.Doc 
    Participant
    Status: Physician
    Posts: 937
    Joined: 02/06/2016

    You might be decent candidate for a defined benefit plan at work.  The tax savings can be substantial.  No need to pay an asset under management fee instead of a moderate fixed annual fee (paid by your business as a necessary expense and not reducing money put into the DB plan).

    Fund the DB plan aggressively early.  Be able to add more money if the market severely contracts and your actuary and third party administrator say you need to kick in more money.

    I wasn’t terribly impressed with the stable value funds that were the default position for our defined benefit plan.  Like Molar Mechanic, we went with Vanguard balanced (VBIAX).  We have contributed far, far more than the minimum required by our employee census for the last few years.  In the unlikely event that we’re called upon to kick in a good chunk more cash to keep the actuary and the Department of Labor happy, we almost certainly will be buying at fire-sale prices.

     

     

    Click to expand…

    Yes, the current income tax savings are very substantial with the proposed defined benefit plan.

    But, the future taxes could be higher on the back end with RMDs at whatever the income tax rates are when taking those RMDs.  Using this defined benefit plan could also lead to higher taxes for the estate, depending on future estate tax exemptions and rates.

    Pay now or pay later.  Psychologically, I feel like the money in our taxable accounts belongs to us, whereas the money in our tax deferred accounts is shared ownership, me and my partner, my great Uncle Sam.

    #240926 Reply
    Avatar jacoavlu 
    Moderator
    Status: Physician, Small Business Owner
    Posts: 2381
    Joined: 03/01/2018

    You don’t have to contribute the max amount for you that is allowed. You can define the benefit to a lower amount. If your projections have you ending up with too much in pretax.

    So the contributions for HCEs come from their comp, not from you the employer? Question, what if returns in the plan are lower than projected, and additional contributions have to be made to make up the shortfall? Is such makeup contributions also going to come from each HCEs comp, or from you? If from their comp then they need to understand this clearly from the outset and document so in writing. You don’t want surprises or “I didn’t know this could happen.”

    I would think HCEs May also deserve a chance to see what sort of investment is happening in the plan, if they were expected to fund makeup contributions in the case of lower than projected returns.

    The Finance Buff's solo 401k contribution spreadsheet: https://goo.gl/6cZKVA

    #240943 Reply
    White.Beard.Doc White.Beard.Doc 
    Participant
    Status: Physician
    Posts: 937
    Joined: 02/06/2016

    You don’t have to contribute the max amount for you that is allowed. You can define the benefit to a lower amount. If your projections have you ending up with too much in pretax.

    So the contributions for HCEs come from their comp, not from you the employer? Question, what if returns in the plan are lower than projected, and additional contributions have to be made to make up the shortfall? Is such makeup contributions also going to come from each HCEs comp, or from you? If from their comp then they need to understand this clearly from the outset and document so in writing. You don’t want surprises or “I didn’t know this could happen.”

    I would think HCEs May also deserve a chance to see what sort of investment is happening in the plan, if they were expected to fund makeup contributions in the case of lower than projected returns.

    Click to expand…

    The HCEs are currently getting 25 or 30k in contributions from the employer to the base 401k/profit sharing plan.  They are also electing to contribute 19k or 25k elective salary deferral.  So on average around 50k in total contributions for the HCEs. Each employee gets to elect which Vanguard funds they want to invest in, stocks, bonds, international or target date.  The most common election, also the default, is target date through Vanguard.  The annual cost to the employees is perhaps about 8 bps in fund fees(0.08%) as the employer pays all other fees.

    The pension consultant recommended perhaps reducing contributions for the HCEs just a bit since they would have no limit on their elective deferrals, but that is optional and not necessary.

    The defined benefit plan would only be for the owner as this would be a combination plan only for the owner. The HCEs would already have as much deferral space as they desire through the 401k profit sharing plan.  I need to confirm that feature as it doesn’t pass the smell test, but that is what the consultant said.

    If returns in the defined benefit plan are lower than expected, then higher contributions could be needed later, so that is why the consultant recommended lower risk investments during the funding phase.  However, this would not affect the employees. The owner would simply shift more personal taxable income to the cash balance plan.  Also, the pension consultant said these contribution amounts could be adjusted yearly within a fairly wide band for the defined benefit plan.

    #240954 Reply
    Avatar jacoavlu 
    Moderator
    Status: Physician, Small Business Owner
    Posts: 2381
    Joined: 03/01/2018

    Either I’m misunderstanding, or you’re misunderstanding.

    Highly compensated employees are already maxing their elective salary deferral to the 401(k) plan you have stated. Additional contributions to the 401(k) plan have to come either from employer match/profit sharing, or if from the employee they would only be voluntary after-tax contributions which I don’t believe is what anyone here is talking about.

    Therefore, when you say the highly compensated employees would have additional deferral space, those funds must be going into the cash balance plan, which would make sense. I don’t believe a cash balance plan only for the owner, with 100% exclusion of employees is possible. You should clarify with the consultant.

    The Finance Buff's solo 401k contribution spreadsheet: https://goo.gl/6cZKVA

    #240964 Reply
    Avatar Tim 
    Participant
    Status: Accountant
    Posts: 3079
    Joined: 09/18/2018

    Philosophically, the principal of sharing the wealth is a business model that works extremely well.
    The issue your are discussing is focused on taxes and the best way to structure them considering both income and estate taxes. From an employee benefit standpoint, it’s fundamentally:
    Total cost= Uncle Sam + net paycheck + deferred comp (taxed later and restrictions with penalties).

    I would suggest basing your decision on what’s best for the organization and the employees. Don’t let the tax tail wag the employee benefits dog. As in the past, you are trying to balance the needs of two parties, owner and employees. Not easy, but that’s why you are the owner.
    Good luck.

    #240965 Reply
    White.Beard.Doc White.Beard.Doc 
    Participant
    Status: Physician
    Posts: 937
    Joined: 02/06/2016

    Either I’m misunderstanding, or you’re misunderstanding.

    Highly compensated employees are already maxing their elective salary deferral to the 401(k) plan you have stated. Additional contributions to the 401(k) plan have to come either from employer match/profit sharing, or if from the employee they would only be voluntary after-tax contributions which I don’t believe is what anyone here is talking about.

    Therefore, when you say the highly compensated employees would have additional deferral space, those funds must be going into the cash balance plan, which would make sense. I don’t believe a cash balance plan only for the owner, with 100% exclusion of employees is possible. You should clarify with the consultant.

    Click to expand…

    The pension consultant said that in addition to the employer contribution, the employee could request an additional contribution from their own pay.

    Example:

    Base pay 300k

    Elective employee deferral 19k

    Employer contribution 30k

    Employee wants to shelter an extra 100k on top of the other contributions, so the employer reduces base pay to 200k, then makes an extra 100k contribution to the profit sharing plan.  What seemed funny is the consultant said that a 300k employee married to a 700k spouse working for another entity could elect to contribute the majority of their salary in this way by lowering their base pay and taking all that extra compensation in a profit sharing contribution.  Even though the pension consultant said that is possible based on the contributions for all of the non-HCE employees getting generous contributions and passing all fairness testing hoops, I have never heard of something that allows that level of contribution above the limit of 56k for younger employees and 62k for older employees.  What the pension consultant said is not making sense to me.  I have a follow up call with them next week to ask for further clarification.

    #241015 Reply
    Avatar HumbleInvestor 
    Participant
    Status: Physician, Small Business Owner
    Posts: 209
    Joined: 12/28/2016

    The key portion is “passing all fairness testing hoops”. I contributed atleast 8.5% (3.5% + 5%) to my non HCEs as match and profit sharing and went up to 10% PS to cross the testing hoops. I would love to see how this plays out.

    #241029 Reply
    Avatar jacoavlu 
    Moderator
    Status: Physician, Small Business Owner
    Posts: 2381
    Joined: 03/01/2018
    Employee wants to shelter an extra 100k on top of the other contributions, so the employer reduces base pay to 200k, then makes an extra 100k contribution to the profit sharing plan.

    Click to expand…

    this can not be the case because that would exceed the 415c limit. The extra 100k has to be going into the DBP.

    What seemed funny is the consultant said that a 300k employee married to a 700k spouse working for another entity could elect to contribute the majority of their salary in this way by lowering their base pay

    I don’t know if this is possible or not, it very well may be. Hopefully one of the several financial advisor folks on here that deal with DBPs will chime in.

    I have never heard of something that allows that level of contribution above the limit of 56k for younger employees and 62k for older employees.  What the pension consultant said is not making sense to me.

    Click to expand…

    this we agree on

    The Finance Buff's solo 401k contribution spreadsheet: https://goo.gl/6cZKVA

    #241037 Reply

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