Is a Cash Balance Plan Right for You? Part 2

Real world examples and risk factors to consider
Robert J. Pyle, CFP®, CFA

As we discussed in Part 1, if you’re a high-earning business owner or professional Cash Balance Plans (CBPs) are an excellent tool for supercharging the value of your nest egg in the last stretch of your career. They can possibly enable you to retire even sooner than you thought you could. Here are some examples of how CBPs can work for you:

Real world examples

I just completed a proposal for a dentist who earned a $224,000 salary. At that income level, he could have maxed out his annual SEP contribution at $56,000…..or he could sock away $143,000 a year via a CBP. Even better, the CBP enabled him to make an additional retirement contributions for her staff.  When times are flush, most high-earning entrepreneurs and professionals don’t have to think twice about making their CBP contributions. But, what about when the financial markets and economy are in the tank?

Back in 2008, at the start of the global financial crisis, a couple came to me because they wanted to save the maximum before they planned to stop working. The wife was a corporate executive and the husband was a self-employed entrepreneur.  Both were in their early 60s and wanted to retire in half a dozen years. The corporate executive was already saving the maximum in her 401(k) and continued to do so from 2008 ($20,500) through 2014 ($23,500). The self-employed entrepreneur, age 61 at the time, was making about $200,000 a year and wanted to set up a plan to shelter his self-employed income.

We explored a defined benefit plan (DB) because that allowed the couple to save significantly more than they could have saved via a 401(k) alone. In fact, the single 401(k) could be paired with the defined benefit plan for extra deferral, if desired. The couple was a good fit for a defined benefit plan since they were in their early 60s, and the entrepreneur was self-employed and had no employees. We completed the paperwork and set a target contribution rate of $100,000 per year for the defined benefit plan and they were off and saving. 

Despite the terrible stock market at the start of their savings initiative, they managed to contribute $700,000 to the DB by the time they retired in 2014--all of which was tax deductible. This strategy ended up saving them about $140,000 in taxes. They also contributed to a Roth 401(k) in the early years of their savings commitment, when the market was low and that money grew tax-free.

With a DBP, you typically want to have a conservative portfolio with a target rate of return pegged at roughly 3 percent to 5 percent. You want stable returns so you will have predictable contribution amounts each year. The portfolio we constructed was roughly 75 percent bond funds and 25 percent stock funds. That allocation helped the couple preserve capital during the market slump of 2008-2009 because we dollar cost averaged the funding for the plan over its duration.

With this strategy, you don’t want to exceed a 5-percent return by too much because your contribution decreases and thus, your tax deduction decreases. On the other hand, if the portfolio generates a really poor return, then you, the employer have to make up a larger contribution. If you have a substandard return, it typically corresponds to a weak economy and you have to make up a larger contribution when your income is off. So, you want to set the return target at a reasonable, conservative level.

Solution

We rolled over the DBP into an IRA and the Roth 401(k) to a Roth IRA. For the corporate executive, we rolled over her 401(k) to an IRA.  They were now set for retirement and can continue to enjoy life without the worry as to how to create their retirement paycheck. 

Are there any income and age limits for contributing to a CBP?

Income limits are $280,000 a year in W-2 income. Depending on your age, you could potentially contribute over 90 percent of that income into a CBP.

Source, The Retirement Advantage  2019 | Click here for complete table

For successful professionals, a good time to set up a CBP is during your prime earning years, typically between age 50 and 60. You certainly don’t want to wait until age 70 to start a CBP because you want to be able to make large tax-advantage contribution for at least three to five years. You can’t start a CBP and then shut it down after only one year.

We did a proposal for an orthodontist recently who liked the idea of a CBP for himself, but he also wanted to reward several long time employees. Unfortunately, the ratios weren’t as good as we would have liked since many of the employees were even older than the owner, so they would have required a much larger contribution. The ratio in this case was 80 percent of the contribution to the owner and 20 percent to the employees. We like to see the ratio in the 85- to 90-percent range, however.

Age gap matters

It’s also helpful to have a significant age gap between you and your employees. Many folks don’t realize this. CBPs are “age weighted,” so it helps to have younger employees. Because those employees are older, they’re much closer to retirement, and would need to receive a larger contribution from the plan.

How profitable does your business/practice need to be for a CBP to make sense?

You have to pay yourself a reasonable W-2 salary and you have to have money on top of that for the CBP. A good rule of thumb is to be making at least $150,000 a year consistently from your business or practice. So, if you designed a plan to save $150,000 in the CBP, you’ll need $300,000 in salary plus distributions. What typically happens is the doctor/dentist pays themselves $150,000 a year in salary and then takes $150,000 in distributions from their corporation. Well, that $150,000 now has to go into the CBP, so you have to have a decent amount of disposable income.

Can employees adjust their contributions?
 
A CBP is usually paired with a 401(k) plan, so employees will have their normal 401(k) limits. In a CBP, the employer has to do a CBP “pay credit” as well as a profit-sharing contribution. The pay credit is usually about 3 percent and the profit-sharing contribution is typically in the range of 5-percent to 10- percent of an employee’s pay.

Setting up and administrating a CBP

You want a plan administrator who can navigate all the paperwork and coordinate with your CPA. There are many financial advisors out there who have expertise in setting up CBPs. You don’t have to work with someone locally; just make sure they are highly experienced and reputable.

CBPs can be more costly to employers than 401(k) plans because an actuary must certify each year that the plan is properly funded. Typical costs include $2,000 to $5,000 in setup fees, although setup costs can sometimes be waived. You’re also looking at $2,000 to $10,000 in annual administration fees, and investment-management fees ranging from 0.25 percent to 1 percent of assets.

Risks

CBPs can be tremendously beneficial for retirement saving. Just make sure you and your advisors are aware of the risk of such plans. Remember that you (the owner/employer) bear the actuarial risk for the CBP. Another risk is if the experts of your plan--the actuaries, record-keepers or investment managers—fail to live up to the plan’s expectations. You, the employer ultimately bear responsibility for providing the promised benefit to employees if a key piece of the plan doesn't work. Like a DBP, an underfunded CBP plan requires steady and consistent payments by you, the employer, regardless of economic times or your financial health. The required contributions of a DBP and CBP can strain the weakened financial health of the sponsoring organization. This is a key item to consider when establishing a CBP and what level of funding can be sustained on a go-forward basis. 

Conclusion

If you’re behind in your retirement savings, CBPs are an excellent tool for supercharging the value of your nest egg and can possibly allow you to retire even sooner than you thought. They take a little more set-up and discipline to execute, but once those supercharged retirement account statements start rolling in, I rarely find a successful owner or professional who doesn’t think the extra effort was worth it.

Robert J. Pyle, CFP®, CFA is president of Diversified Asset Management, Inc. (DAMI). DAMI is licensed as an investment adviser with the State of Colorado Division of Securities, and its investment advisory representatives are licensed by the State of Colorado. DAMI will only transact business in other states to the extent DAMI has made the requisite notice filings or obtained the necessary licensing in such state. No follow up or individualized responses to persons in other jurisdictions that involve either rendering or attempting to render personalized investment advice for compensation will be made absent compliance with applicable legal requirements, or an applicable exemption or exclusion. It does not constitute investment or tax advice. To contact Robert, call 303-440-2906 or e-mail info@diversifiedassetmanagement.com.

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