Still a Strong Case for the Cash Balance Plan
“Our new Constitution is now established, everything seems to promise it will be durable; but, in this world, nothing is certain except death and taxes.”
It’s a little-known fact that the first hybrid car dates to the Paris Auto Show of 1900. That means it took almost a century for the world to see mass production of hybrids, when the Toyota Prius came to market in 1997. And did you know that Benjamin Franklin coined the above quote in a letter he wrote in French? No, he didn’t have anything to do with hybrid cars (as far as we know). What we do know: even after tax reform, the axiom still holds in any language. Where do taxes, hybrids, and retirement plans intersect? The fastest growing hybrid in the retirement plan space is the cash balance plan because it offers unparalleled opportunity for business owners to increase savings and defer taxes over and above the traditional 401(k) and profit sharing limits. We hope it doesn’t take another century for this plan design to enter “mass production” for tax-advantaged investing.
WHAT IS A CASH BALANCE PLAN?
Simply put, it’s designed to look like a hybrid between traditional defined benefit (DB) and defined contribution (DC) retirement plans. The plan promises to pay benefits to participants at retirement just like a traditional DB plan. But it has another quality that makes it look more like a DC plan: participant-level account balances are maintained and displayed on a website and/or periodic statements. The balances are made up of contributions plus fixed interest credits. The employer is responsible for making the contributions in accordance with the formula in the plan’s governing document and investing the assets to meet the prescribed fixed interest amount. The bottom line: cash balance plans are outstanding opportunities for employers and employees.
WHY ARE CASH BALANCE PLANS SO GREAT?
For one thing, the contribution limits can be up to five times greater than standard DC 401(k) profit sharing plans. The 2018 maximum annual contributions for DC plans increased to $60,000 for a participant age 50 and older. 5 X $60,000 = a lot of tax deferral. The contribution limits go up as one gets older, so there are some who stand to benefit more than others. The Tax Cuts and Jobs Act did a few things relevant to this discussion:
1) It reduced the marginal tax rates.
2) It reduced corporate tax rates from 35% to 21%.
3) It created a new rule on passive income whereby 20% of qualifying income can be deducted.
The passive income deduction specifically excluded most professional service organizations to include services like health, law, accounting, consulting, and financial services. Additionally, the corporate tax rate cut doesn’t apply to these types of firms. In terms of their primary income source, all the owners of a professional service entity got from the bill was the individual rate cut and a confirmation of Franklin’s old adage.
We will stick with a narrow example with rough estimates for our purposes. Let’s assume we have a married couple, filing jointly, with adjusted gross income of $480,000 primarily the result of one spouses’ work as a partner in a physician practice. After the changes in brackets and marginal rates, they will see their tax liability move from $134,000 to $119,000, for $15,000 in savings. Don’t get us wrong; that is a significant dollar amount. However, the current tax of $119,000 is still a lot of money. Enter the cash balance plan. Those professional service firm owners looking for more tax deferral strategies need not overlook this hybrid vehicle, open to all employers as retirement plan sponsors. The physician could contribute $80,000 to a cash balance plan on his or her behalf and reduce their current tax liability by an additional $28,000, and that savings add up.
ARE THERE OTHER ADVANTAGES?
Why yes there are! Here are some of the more nitty-gritty benefits of cash balance plans.
Flexibility. Different employees can have different contribution formulas, so highly compensated and non-highly compensated can both participate.
Third Party Managed. Investment advisors take on discretionary authority over CB plans so employees need not fret over fund choices, asset allocation, etc.
Portability. This is the fancy term for the ability to move account assets outside of a company’s plan when a participant leaves the firm. Yes, cash balance plan accounts can be rolled over.
Payout Optionality. Cash balance plans typically include the ability to offer participants a lump sum payout rather than a fixed annuity for life, if they prefer, upon retirement.
Catch-up Vehicles. Cash balance plans are great ways to accumulate retirement savings quickly for those who started late in the game or simply haven’t focused on tax advantaged deferrals.
WHAT’S THE CATCH?
So many positives! It may seem like a homer pick—a write up on lesser-known retirement plan options by a retirement plan consulting firm. There are some drawbacks which make the cash balance plan not ideal for every firm.
Complexity. This is probably the number one hurdle. Sponsors don’t know enough to take the time to invest in learning the details.
Perception. There’s the elephant in the room, so to speak—traditional DB plans are heading towards extinction for a reason. Largely this is because plans couldn’t take on enough risk to achieve the annual returns on investment needed to fund overly generous plans.
Investment returns. The typical interest credit hurdle in a cash balance plan is 3-5%. Some think they can do much better in other accounts. They may not be wrong, but we counter that it’s healthier to view these types of plans as tax strategies. With U.S. equity markets hitting all-time high valuations almost daily, the markets may be presenting an ideal time to open such a cash balance plan—a conservative ballast, relatively speaking.
Cost. Relative to 401(k)’s, the start-up costs of a cash balance plan are typically higher—requiring the mathematical gymnastics of an actuary to write plan formulas. These costs typically pale in comparison to the benefits of tax deferrals available.
In summary, professional service firms vigilant about their employees’ future should consider cash balance plans. To be sure, these are best coupled with a 401(k) for maximum saving. Together, they just make sense, and should be utilized while the regulatory environment still considers them friends. As they say in Toyota Prius ads, “More green for less green.”