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Advantages and disadvantages of DC designs

Dec 11, 2008

This is the third in our series of articles on defined contribution (DC) plans other than 401(k) plans. Frequent readers will recall that we started the series in October with an article on the basics of DC plans and followed that in November with an article covering some of the basic design features. This month, we look at some of the pros and cons of different designs by considering situations where a sponsor likely would or would not use a particular type of defined contribution plan. Among the circumstances that we’ll consider are these:

Broad-based uniform plan

Company A seeks to provide its employees with a meaningful addition to their existing 401(k) account balances. Company A would like to provide a similar benefit to all employees. Typically, this can be done through one of three vehicles – a profit sharing plan, a money purchase pension plan or an employee stock ownership plan (ESOP), either leveraged or not. Let’s consider why Company A might use each of these three vehicles to address its concern.

Let us assume that the 401(k) plan is qualified as a profit sharing plan. So, using that profit sharing feature will neither require adopting a new plan nor will it give rise to all the other requirements associated with sponsoring an additional plan. Should the company choose to vary its contribution from year to year, this can be easily affected with a “discretionary” profit sharing contribution. If instead, Company A were to use a money purchase pension plan or an ESOP, it would be locked in to a minimum required contribution. Additionally, if the ESOP under consideration was to be leveraged, Company A would not only have a minimum required contribution, but would also have to contribute enough to “service the underlying loan.” Finally, and we will discuss this in more detail next month, ESOPs have certain compliance issues that may make them less appealing to some plan sponsors than other types of DC plans.

On the other hand, an ESOP might have advantages that could not be gained through other vehicles. The most compelling of these is employee ownership. In fact, many employers believe that employees who have an ownership stake in the company work harder than those who don’t. Of course, companies have the ability to make their own stock an investment option in profit sharing and money purchase pension plans, but when they do, employees may not rush to invest in company stock.

Broad-based plan favoring the higher-paid

Company B is much like Company A, but instead of providing a uniform percentage of pay to a DC plan for all its employees, Company B would like to do something to favor the higher-paid group. Many of the issues will be the same as in the last section, but what we will consider differently here is that the plan may be “integrated” with Social Security.

The IRS has long recognized (at least since Revenue Ruling 71-446) that companies provide one-half of an employee’s eventual Social Security benefit. And, that recognition has gone so far as to conclude that the company contribution is based on the employee’s pay up to the Social Security Wage Base ($106,800 for 2009). Thus, as a percentage of pay, the company contribution to the Social Security system favors those employees making less than the wage base. In the Tax Reform Act of 1986, Congress codified what the IRS had already concluded in Code section 401(l), by allowing profit sharing and money purchase pension plans that are integrated at the wage base to “match” the contribution on pay in excess of the wage base with an equal amount so long as that amount does not exceed 5.7% of pay. This can be illustrated with a couple of examples showing proper integration under Code section 401(l).

Formula 1:	4% of plan compensation up to the Social Security Wage Base plus 8% of plan compensation in excess of the Social Security Wage Base
Formula 2:	7% of plan compensation up to the Social Security Wage Base plus 12.7% of plan compensation in excess of the Social Security Wage Base

We note that Congress allows profit sharing and money purchase plans to be integrated, but generally ESOPs may not be integrated. In other words, for companies that want to skew their contributions toward the higher-paid, ESOPs are not a practical vehicle. And, for the same reasons as with Company A, Company B may be better off using a profit sharing plan than a money purchase plan – more flexibility in amount of contributions and fewer compliance issues.

Significantly favoring the higher-paid

Company C would also like to provide a DC plan that favors its higher-paid employees. But, instead of simply integrating the contributions with Social Security, it would like to heavily skew those contributions to the higher paid. This is the situation where Company C will want to use a “new comparability plan” [we discussed the basics of new comparability plans in our November article].

To fully explain, we need to digress into some of the compliance issues of qualified plans. Under Code section 401(a)(4), a qualified plan may not discriminate significantly in favor of highly compensated employees. Generally, there are two means for a plan sponsor to demonstrate that a plan satisfies this rule. Either, the plan can be a “safe harbor” as defined in Treasury regulations 1.401(a)(4)-2 and -3 (uniform formulas like that provided by Company A and properly integrated formulas like that provided by Company B generally are safe harbor) or the sponsor must demonstrate via a complex testing mechanism that the contributions provided under the plan are nondiscriminatory (a detailed description of how that is done is beyond the scope of this article).

Typically, for a new comparability plan, the design is set up so that the contributions can be “cross-tested” on a benefits basis. In short, rather than testing the (DC-like) allocations, the (DB-like) annuity equivalent at age 65 is tested. The mathematics of the test show that this allows the company to provide significantly higher contributions to older employees than to younger employees (typically, the highly compensated employees as a group are older than the nonhighly compensated employees). In fact, we could demonstrate that a plan that allocates 1% of compensation to a nonhighly compensated employee at age 25 could allocate 25% of compensation to a highly compensated employee at age 65 and be considered nondiscriminatory, so long as the plan is eligible for cross-testing.

ESOPs are not eligible for cross-testing. Therefore, new comparability plans are either profit sharing or money purchase, and for all the reasons that Company A had for preferring profit sharing to money purchase, it is likely that Company C will as well.

Raising money for the business

Company D would like to provide its employees with a DC allocation, and at the same time raise money for the business. This is an ideal situation for a leveraged ESOP, or LESOP. Last month, we described in some detail how they work, but due to the complexity, we will repeat here.

There may be as many as five parties involved in the cash and benefit flow of a LESOP – the company, the employees (participants), a bank (or banks), shareholders, and the plan’s trust. In a nutshell, here is what happens. A bank lends money to the trust, with the company backing the loan. The trust then buys shares of company stock from the company or from shareholders. The company makes annual contributions to the trust, which, in its own right, repays (or services) the loan to the bank. Employees have shares allocated to their LESOP accounts (which they may eventually diversify) and are paid out in shares or cash when they terminate with a vested balance.

Perhaps this can be viewed better graphically:

This transaction may have significant cash benefits to a company. Suppose the company has a sufficient number of authorized but unissued shares that it owns (i.e., treasury shares). By selling those shares to the ESOP trust, the company can raise capital. At the same time, contributions to the ESOP generally are tax deductible, and the loan repayment generally is tax deductible. No other qualified plan transaction that we are aware of has all these interesting financial benefits.

Family-owned company

Company E also wants to provide a DC plan to its employees. But, it is in a different situation. Company E was founded many years ago by Mr. X. Since Company E has been a successful company, Mr. X is now a very wealthy man, but at age 75, much of that wealth is tied up in shares of Company E stock. Should Mr. X die in a year when the federal estate tax is in effect, Mr. X’s estate could owe significantly more tax than it has cash available. To pay that tax, Mr. X’s estate will likely have to sell off shares of Company E stock at a profit, and then owe capital gains tax on that profit. So, from the estate’s standpoint, it seems that taxes are inescapable.

This is another ideal situation for an ESOP. And, in this case, Company E and its principal shareholder, Mr. X, may find it financially advantageous to engage in what is frequently known as a “1042 exchange” named after Code section 1042. The process is somewhat complicated.

Mr. X sells enough stock to the ESOP so that the ESOP owns at least 30% of the total value of all outstanding shares of Company E. Mr. X then uses the proceeds of that sale to buy “qualified replacement property” (generally securities issued by another domestic operating corporation). The qualified replacement property must be acquired during the 15-month period ending one year after the date of the sale of shares to the ESOP. And, Mr. X may not participate in the ESOP.

Mr. X then elects a deferral of gain under Code section 1042 (his tax advisor can provide guidance on how to make that election). Once Mr. X has elected deferral of gain and reinvested the sale proceeds in qualified replacement property, his basis in the newly acquired securities is reduced by the amount of gain not recognized. Further, the real benefit is that tax on the gain can be avoided altogether if Mr. X holds the replacement property until his death, at which time the Mr. X’s estate will receive a “step-up” in basis to the value as of the date of his death, thereby avoiding capital gains altogether.

Defined benefit replacement

Company F has long sponsored a final-average-earnings-based defined benefit plan. Its management likes the types of benefits provided by the DB plan, but management doesn’t like the rules. Fortunately for Company F, there is a type of DC plan to solve this problem.

A target benefit plan is a DC plan with an underlying DB formula. In a sense, it is the converse to the more familiar cash balance plan which is a DB plan with a DC formula. Here are the basics of how a target benefit plan works.

The plan sponsor develops an underlying defined benefit formula that may be integrated with Social Security. An example might be 1% of five-year final average earnings per year of service. Each year, an actuary makes a determination based on an employee’s account balance, the account balance he is projected to need at his assumed retirement age to pay his formulaic benefit, a group of actuarial assumptions and methods, and certain other data points.

This sort of design typically appeals to companies that have the same human resources goals as sponsors of DB plans have (career employees, reward high performers, etc.), but for one reason or another (e.g., investment risk) do not want to sponsor a DB plan.

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In next month’s article, we will focus on some of the compliance and related issues for these defined contribution plans.