When you talk to clients about defined benefit plans, inevitably the question comes up, "What happens if I can't make my contribution one year?"
While we've always had ways to work with a client who's situation changes, several new approaches are available in this post-Pension Protection Act (PPA) world. We'll use the best approach depending on your client's needs — you can be assured. Here are a few things we can do:
Plan Design
In general, we establish the benefit average during the first 3 years of the plan's existence. While the ultimate benefit payable from the plan is based on the highest 3 consecutive years, we rarely use compensation earned prior to the effective date of the plan as the basis for the benefit unless it works to the client's advantage.
Here's an example that shows how this gives your client with fluctuating income a great deal of flexibility: The 52 year old owner of a business receives a W-2 of $100,000. In the first year of the plan, the actuary would project the maximum benefit at retirement as $100,000 per year. This would require a contribution of approximately $67,700. (If the owner prefers, a lower benefit formula could be established from the beginning.)
In the second year of the plan, the owner's W-2 drops to $40,000. The plan benefit would then be based on the first year compensation of $100,000, the second year's compensation of $40,000, and a projected third year's compensation of $40,000. This would give us an average compensation for years 1, 2 and projected 3 of $60,000. With the lower benefit of $60,000, the contribution for the second year would be reduced to approximately $50,000, assuming level funding.
If the income goes back up in the third year, the actuary would use the new compensation as the basis for the benefits. If it remains less than $100,000, the actuary would average years 1 and 2 with the third year's compensation to arrive at the contribution for the third year. The amount of the benefit, and the contribution, will be adjusted based on the W-2 paid, which creates flexibility in the contribution
Pension Protection Act
Under the PPA, a client can contribute up to 150% of the funding target. Using the same facts as in the first example, the funding target for year 1 is $67,700. This means that the client can contribute between $67,700 and $101,500. Since clients are generally setting up defined benefit plans in order to take advantage of the larger deductions, many of them will take advantage of the additional contribution available and make the full $101,500 contribution. This has created a credit for the plan of $34,000 that the plan sponsor can use in a future year when he cannot make the full required contribution.
Again assuming the same facts as the first example for year 2, the client could utilize the plan credit and make a contribution of only $16,000 if that is what he desires.
If the additional contributions are made over the first three years of the plan, this would enable the plan sponsor to contribute nothing, if that is his or her desire in a future year. You can't have greater flexibility than this. Please note that this second example is based to some extent on the assumption that the Technical Corrections Act to the Pension Protection Act, which has been introduced in Congress, will pass before year end.
Amending the Plan
If the other methods will not reduce the contribution to an acceptable level, it is possible to amend the plan's benefit formula to a lower benefit formula.
As in the first example, assume that the plan was originally designed to provide a benefit of 100% of compensation. This was also the benefit level provided by the plan in the second and third years of the plan. In the fourth year, the income of the business is not sufficient to continue funding at the previous level. The plan could be amended to change the benefit from 100% of compensation to 25% of compensation. This means that the annual benefit provided at retirement will now be $25,000 instead of $100,000. Because the plan was funding for a benefit of $100,000 the first three years, the funding levels are now much greater than necessary to provide a $25,000 annual benefit. IN this case, the required contribution for the year could be reduced to as low as nothing.
Please note that there are certain rules applicable to the lowering of a benefit formula. Based on the timing of the amendment, it may not be applicable until the following year. It may also trigger IRS scrutiny if the benefit formula is reduced too much or too often.
Bring Us into Your Conversations
So, when your client asks a defined benefit question Ð bring us in to pick the best solution. We can participate on a conference call with you and your client to talk about objectives and we'll help you open the plan.
Call 1-866-269-2706 or email us at DBPlans@dedicated-db.com.
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