Optimizing Retirement Plans for Law Firms

Recent changes in the legislative and regulatory climate have made it possible and desirable to consider optimizing retirement plan contributions by combining defined benefit and defined contribution plans. But while combination plans can produce superior benefits, their designers must ensure that plans do not violate:

• The Internal Revenue Code rule that a plan qualified for favorable tax treatment must avoid discriminating in favor of highly compensated employees; or
• The requirement in the Age Discrimination in Employment Act (ADEA) that pension plans must not discriminate against employees on the basis of age.

In Part One of this article, we introduce and compare some of these possibilities. In Part Two, we will provide spreadsheet analyses of these plans to illustrate their effectiveness and address discrimination concerns.

Basic Plan Types

A defined benefit pension plan defines the ultimate benefit to be paid; eg, a lifetime benefit of $10,000 per month, beginning at age 65. An actuary then determines the amount necessary to contribute annually to fund that benefit. If earnings are less than anticipated, the required annual contributions increase. If earnings are more, then the required annual contributions decrease. For the year 2004, the maximum benefit that may be provided by a defined benefit plan, beginning at age 62, is $165,000 per year. This benefit cannot exceed the participant's final average annual pay.

A defined contribution pension plan defines the amount to be contributed ' eg, 5% of pay each year. The benefit eventually paid will depend not only on the amounts contributed but also on the plan's investment performance. The annual limit on total contributions to defined contribution plans for a participant (including 401(k) contributions) is 100% of pay or $41,000, whichever is less.

A defined contribution profit sharing plan defines how the employer's contribution, if any, will be divided among the participants ' but the employer has the discretion, within limits, to determine on a year-by-year basis the amount of the overall contribution. The examples of defined contribution plans discussed in this article are all profit sharing plans.

Defined benefit plans tend to provide greater value for older and long-term employees. Defined contribution plans tend to provide greater benefits for younger and short-term employees. The break point, the age where the value of a maximum defined benefit accrual exceeds the value of a maximum defined contribution allocation, is somewhere in the 30s, depending upon the anticipated retirement age, form of payment, and marital status.

Over time, the advantage of a defined benefit plan vs. a defined contribution plan increases dramatically. For an individual age 40, the maximum contribution to a defined contribution plan would remain at $41,000. In contrast, the value of the maximum annual accrual at that age in a defined benefit plan, and the potential associated deductible contribution, could range from $71,500 to $81,500. By age 55, the annual accrual could rise to $148,000 to $177,000.

Combining Plan Types

Defined contribution plans also have some advantages, however, so it may often make sense for professionals to participate fully in defined contribution plans in their early years, and then switch to a defined benefit plan in their later years. Moreover, it may make sense, to maximize benefits, contributions, and flexibility, for some professionals to participate in both types of plans at the same time. With such a combination of plans, an individual earning $205,000 per year at age 40 could accrue and contribute up to $122,500 per year. A similar individual who was age 55 could accrue and contribute up to $218,000.

Moreover, by using a discretionary profit sharing plan as part of the combination, an employer could build in flexibility, so that the annual contribution could vary between $81,500 and $122,500 for the 40-year old and between $177,000 and $218,000 for the 55-year old.

There are many approaches to combining defined contribution and defined benefit plans to maximize benefits for the principals. This article illustrates how a profit-sharing defined contribution plan can be combined with three different types of defined benefit plan: a cash balance plan, a deferred pension equity plan (PEP plan), and a traditional career-average plan.

We prefer the first alternative ' a profit-sharing defined contribution plan with a cash balance defined benefit plan ' because participants and employers can most easily understand the mathematics and fairness of that combination.

We describe below how a cash balance plan and a deferred PEP plan work. (We assume that readers are familiar with the traditional career-average plan.) We also discuss recent court challenges and legislative developments related to cash balance plans.

In Part Two we will detail how these three alternatives compare. We will explain how such plans can be shown to satisfy nondiscrimination requirements, through techniques called “cross testing” and “new comparability.”

Cash Balance Plans

A cash balance plan is a hybrid ' a defined benefit plan that mimics the operation of a defined contribution plan. A cash balance plan defines its ultimate benefit by reference to a hypothetical account balance and to hypothetical earnings that are added to the account each year. These earnings are based on an index, eg, the one-year Treasury rate. When a participant retires or otherwise terminates employment, his or her lump sum benefit is generally equal to the hypothetical account balance.

Note: If the employee is married, the spouse must consent in writing for the benefit to be received as a lump sum. The default method of payment in all defined benefit plans is an annuity.

As remarked previously, we find that participants seem able to understand cash balance plans more easily than traditional pension plans.

Another advantage of a cash balance plan is that the allocation of its cost among the principals ' usually a non-shared expense ' is easier to calculate and understand than for a traditional pension plan. Generally, the non-shared expense is equal to, or based on, the hypothetical cash balance allocation to the principal. The allocation of that expense can be adjusted in a straightforward way to the extent that plan earnings are greater or less than the hypothetical interest credits.

In order to minimize the amount of under- or over-funding in any year, plan assets can be invested to approximate the interest crediting rate. This reduces the potential for disputes that arise when a plan becomes significantly under- or over-funded. Smaller gaps in funding should usually be closed once a year.

Alternatively, the plan's assets can be invested in a more traditional asset allocation, say with a 60%-40% or 70%-30% ratio of equity to fixed income. The increased potential return from such investments can be used to offset other plan costs.

Participant direction of investment is not permitted in traditional cash balance plans. However, participants are allowed to treat their plan balance as part of their fixed income portfolio and adjust their “investment strategies” outside of the cash balance plan. For example, participants who desire a 60%-40% ratio of equity to fixed income could treat their cash balance “account” as part of their fixed income portfolio, and increase their allocation of equity based assets outside of the cash balance plan accordingly.

Legal Challenges to Cash Balance Plans

Like defined contribution plans, cash balance plans tend to benefit younger, shorter-term employees more than traditional pension plans do. Older workers have therefore brought several lawsuits to oppose the conversion of traditional pension plans into cash balance plans. These lawsuits, based on anti-discrimination provisions of the Age Discrimination in Employment Act, have had mixed results.

In a recent well-publicized decision, Cooper v. IBM Personal Pension Plan (274 F.Supp.2d 1010 (S.D. Ill. 2003)), a U.S. District Judge in St. Louis held that IBM's typical cash balance plan design violated the ADEA. We think it likely, however, that the Cooper decision will be overturned on appeal.

Meanwhile, in an unpublished decision issued four months after the Cooper decision, the Ninth Circuit Court of Appeals held that the ADEA was not violated either by the design of a typical cash balance plan or by the conversion to such a plan from a traditional plan. (Godinez v. CBS Corp., 2003 U.S. App. LEXIS 23923 (9th Cir. 2003).)

Another publicized recent decision involving Xerox Corporation's cash balance plan did not actually address the legality of the plan concept itself. The ruling against Xerox pertained rather to the calculation of lump sum benefits under the plan.

The U.S. Treasury Department has proposed regulations that would set forth standards under which cash balance plans and conversions would comply with the ADEA. However, House and Senate negotiators recently agreed to legislation that forbids Treasury from finalizing those regulations. Instead, the House-Senate compromise plan directs Treasury to propose legislation on the subject within six months.

We assume, for purposes of this article, that the basic cash balance plan structure does comply with the ADEA ' and will continue to do so after any legislative amendments in the near future.

Deferred Pension Equity Plans

As just described, a cash balance plan defines its retirement benefit in terms of a hypothetical allocation that accrues value as hypothetical interest credits are added to it. By contrast, a deferred PEP plan defines its result as an age-65 lump sum retirement benefit, from which a reduction for early commencement would be subtracted.

The deferred PEP plan's age-65 lump sum is based on a percentage of the employee's pay (either final average pay or career-average pay). For example, if the deferred PEP formula is 10% of final average pay times years of service, an 11-year employee retiring at age 65 with a final average pay of $200,000 per year would be entitled to a lump sum benefit of $220,000.

If a participant leaving before age 65 requests an immediate lump sum payment, a deferred PEP plan pays the age-65 benefit reduced by some percentage, say 2%, for each year that the payment precedes age 65. If in the above example the retiring employee were only 64, the lump sum amount would be $220,000 less 2%, or $215,600.

Even under the faulty ADEA analysis of the district court in the IBM case, we believe the deferred PEP plan would pass muster with regard to age discrimination.

Participants find deferred PEP plans more understandable than traditional pension plans, although slightly less so than cash balance plans.

Dividing the non-shared costs of a deferred PEP plan is only slightly more complicated than for a cash balance plan. Here the starting point is the difference between the hypothetical payment if the participant leaves at the end of the current year vs. the hypothetical payment if the participant had left at the end of the preceding year.

As with a cash balance plan, the asset allocation of plan investments can be structured either a) to reduce the possibility of under- or over-funding from year to year, or b) to increase the possibility of additional return, so as to offset other plan costs.

Traditional Career-Average Plan

A final approach to consider is combining a traditional career-average pension plan (with a lump sum distribution option) with a profit sharing plan. The amount of the lump sum in a career-average plan is tied to a statutory index, and can fluctuate from year to year.

Conclusion

Using any of the described combination plans, law partners can generate larger retirement pensions than would be possible using either plan alone.

As will be demonstrated in Part Two of this article, it appears likely that all these combination plans (with the possible exception of the PEP combination) can be structured to comply with IRC and ADEA nondiscrimination requirements. That can be accomplished even if the firm decides to allocate a very high percentage of the plan benefits to partners. To observe the spirit of nondiscrimination laws, of course, partners should consider whether their support staff (and participating associates, if any) do not deserve far more than a minimum share of the firm's retirement plan benefits.

Recent changes in the legislative and regulatory climate have made it possible and desirable to consider optimizing retirement plan contributions by combining defined benefit and defined contribution plans. But while combination plans can produce superior benefits, their designers must ensure that plans do not violate:

• The Internal Revenue Code rule that a plan qualified for favorable tax treatment must avoid discriminating in favor of highly compensated employees; or
• The requirement in the Age Discrimination in Employment Act (ADEA) that pension plans must not discriminate against employees on the basis of age.

In Part One of this article, we introduce and compare some of these possibilities. In Part Two, we will provide spreadsheet analyses of these plans to illustrate their effectiveness and address discrimination concerns.

Basic Plan Types

A defined benefit pension plan defines the ultimate benefit to be paid; eg, a lifetime benefit of $10,000 per month, beginning at age 65. An actuary then determines the amount necessary to contribute annually to fund that benefit. If earnings are less than anticipated, the required annual contributions increase. If earnings are more, then the required annual contributions decrease. For the year 2004, the maximum benefit that may be provided by a defined benefit plan, beginning at age 62, is $165,000 per year. This benefit cannot exceed the participant's final average annual pay.

A defined contribution pension plan defines the amount to be contributed ' eg, 5% of pay each year. The benefit eventually paid will depend not only on the amounts contributed but also on the plan's investment performance. The annual limit on total contributions to defined contribution plans for a participant (including 401(k) contributions) is 100% of pay or $41,000, whichever is less.

A defined contribution profit sharing plan defines how the employer's contribution, if any, will be divided among the participants ' but the employer has the discretion, within limits, to determine on a year-by-year basis the amount of the overall contribution. The examples of defined contribution plans discussed in this article are all profit sharing plans.

Defined benefit plans tend to provide greater value for older and long-term employees. Defined contribution plans tend to provide greater benefits for younger and short-term employees. The break point, the age where the value of a maximum defined benefit accrual exceeds the value of a maximum defined contribution allocation, is somewhere in the 30s, depending upon the anticipated retirement age, form of payment, and marital status.

Over time, the advantage of a defined benefit plan vs. a defined contribution plan increases dramatically. For an individual age 40, the maximum contribution to a defined contribution plan would remain at $41,000. In contrast, the value of the maximum annual accrual at that age in a defined benefit plan, and the potential associated deductible contribution, could range from $71,500 to $81,500. By age 55, the annual accrual could rise to $148,000 to $177,000.

Combining Plan Types

Defined contribution plans also have some advantages, however, so it may often make sense for professionals to participate fully in defined contribution plans in their early years, and then switch to a defined benefit plan in their later years. Moreover, it may make sense, to maximize benefits, contributions, and flexibility, for some professionals to participate in both types of plans at the same time. With such a combination of plans, an individual earning $205,000 per year at age 40 could accrue and contribute up to $122,500 per year. A similar individual who was age 55 could accrue and contribute up to $218,000.

Moreover, by using a discretionary profit sharing plan as part of the combination, an employer could build in flexibility, so that the annual contribution could vary between $81,500 and $122,500 for the 40-year old and between $177,000 and $218,000 for the 55-year old.

There are many approaches to combining defined contribution and defined benefit plans to maximize benefits for the principals. This article illustrates how a profit-sharing defined contribution plan can be combined with three different types of defined benefit plan: a cash balance plan, a deferred pension equity plan (PEP plan), and a traditional career-average plan.

We prefer the first alternative ' a profit-sharing defined contribution plan with a cash balance defined benefit plan ' because participants and employers can most easily understand the mathematics and fairness of that combination.

We describe below how a cash balance plan and a deferred PEP plan work. (We assume that readers are familiar with the traditional career-average plan.) We also discuss recent court challenges and legislative developments related to cash balance plans.

In Part Two we will detail how these three alternatives compare. We will explain how such plans can be shown to satisfy nondiscrimination requirements, through techniques called “cross testing” and “new comparability.”

Cash Balance Plans

A cash balance plan is a hybrid ' a defined benefit plan that mimics the operation of a defined contribution plan. A cash balance plan defines its ultimate benefit by reference to a hypothetical account balance and to hypothetical earnings that are added to the account each year. These earnings are based on an index, eg, the one-year Treasury rate. When a participant retires or otherwise terminates employment, his or her lump sum benefit is generally equal to the hypothetical account balance.

Note: If the employee is married, the spouse must consent in writing for the benefit to be received as a lump sum. The default method of payment in all defined benefit plans is an annuity.

As remarked previously, we find that participants seem able to understand cash balance plans more easily than traditional pension plans.

Another advantage of a cash balance plan is that the allocation of its cost among the principals ' usually a non-shared expense ' is easier to calculate and understand than for a traditional pension plan. Generally, the non-shared expense is equal to, or based on, the hypothetical cash balance allocation to the principal. The allocation of that expense can be adjusted in a straightforward way to the extent that plan earnings are greater or less than the hypothetical interest credits.

In order to minimize the amount of under- or over-funding in any year, plan assets can be invested to approximate the interest crediting rate. This reduces the potential for disputes that arise when a plan becomes significantly under- or over-funded. Smaller gaps in funding should usually be closed once a year.

Alternatively, the plan's assets can be invested in a more traditional asset allocation, say with a 60%-40% or 70%-30% ratio of equity to fixed income. The increased potential return from such investments can be used to offset other plan costs.

Participant direction of investment is not permitted in traditional cash balance plans. However, participants are allowed to treat their plan balance as part of their fixed income portfolio and adjust their “investment strategies” outside of the cash balance plan. For example, participants who desire a 60%-40% ratio of equity to fixed income could treat their cash balance “account” as part of their fixed income portfolio, and increase their allocation of equity based assets outside of the cash balance plan accordingly.

Legal Challenges to Cash Balance Plans

Like defined contribution plans, cash balance plans tend to benefit younger, shorter-term employees more than traditional pension plans do. Older workers have therefore brought several lawsuits to oppose the conversion of traditional pension plans into cash balance plans. These lawsuits, based on anti-discrimination provisions of the Age Discrimination in Employment Act, have had mixed results.

In a recent well-publicized decision, Cooper v. IBM Personal Pension Plan (274 F.Supp.2d 1010 (S.D. Ill. 2003)), a U.S. District Judge in St. Louis held that IBM's typical cash balance plan design violated the ADEA. We think it likely, however, that the Cooper decision will be overturned on appeal.

Meanwhile, in an unpublished decision issued four months after the Cooper decision, the Ninth Circuit Court of Appeals held that the ADEA was not violated either by the design of a typical cash balance plan or by the conversion to such a plan from a traditional plan. (Godinez v. CBS Corp., 2003 U.S. App. LEXIS 23923 (9th Cir. 2003).)

Another publicized recent decision involving Xerox Corporation's cash balance plan did not actually address the legality of the plan concept itself. The ruling against Xerox pertained rather to the calculation of lump sum benefits under the plan.

The U.S. Treasury Department has proposed regulations that would set forth standards under which cash balance plans and conversions would comply with the ADEA. However, House and Senate negotiators recently agreed to legislation that forbids Treasury from finalizing those regulations. Instead, the House-Senate compromise plan directs Treasury to propose legislation on the subject within six months.

We assume, for purposes of this article, that the basic cash balance plan structure does comply with the ADEA ' and will continue to do so after any legislative amendments in the near future.

Deferred Pension Equity Plans

As just described, a cash balance plan defines its retirement benefit in terms of a hypothetical allocation that accrues value as hypothetical interest credits are added to it. By contrast, a deferred PEP plan defines its result as an age-65 lump sum retirement benefit, from which a reduction for early commencement would be subtracted.

The deferred PEP plan's age-65 lump sum is based on a percentage of the employee's pay (either final average pay or career-average pay). For example, if the deferred PEP formula is 10% of final average pay times years of service, an 11-year employee retiring at age 65 with a final average pay of $200,000 per year would be entitled to a lump sum benefit of $220,000.

If a participant leaving before age 65 requests an immediate lump sum payment, a deferred PEP plan pays the age-65 benefit reduced by some percentage, say 2%, for each year that the payment precedes age 65. If in the above example the retiring employee were only 64, the lump sum amount would be $220,000 less 2%, or $215,600.

Even under the faulty ADEA analysis of the district court in the IBM case, we believe the deferred PEP plan would pass muster with regard to age discrimination.

Participants find deferred PEP plans more understandable than traditional pension plans, although slightly less so than cash balance plans.

Dividing the non-shared costs of a deferred PEP plan is only slightly more complicated than for a cash balance plan. Here the starting point is the difference between the hypothetical payment if the participant leaves at the end of the current year vs. the hypothetical payment if the participant had left at the end of the preceding year.

As with a cash balance plan, the asset allocation of plan investments can be structured either a) to reduce the possibility of under- or over-funding from year to year, or b) to increase the possibility of additional return, so as to offset other plan costs.

Traditional Career-Average Plan

A final approach to consider is combining a traditional career-average pension plan (with a lump sum distribution option) with a profit sharing plan. The amount of the lump sum in a career-average plan is tied to a statutory index, and can fluctuate from year to year.

Conclusion

Using any of the described combination plans, law partners can generate larger retirement pensions than would be possible using either plan alone.

As will be demonstrated in Part Two of this article, it appears likely that all these combination plans (with the possible exception of the PEP combination) can be structured to comply with IRC and ADEA nondiscrimination requirements. That can be accomplished even if the firm decides to allocate a very high percentage of the plan benefits to partners. To observe the spirit of nondiscrimination laws, of course, partners should consider whether their support staff (and participating associates, if any) do not deserve far more than a minimum share of the firm's retirement plan benefits.