By Mark Papalia, CLU
In today’s business climate, companies continue to explore every opportunity to minimize benefits costs while still being able to provide value to their employees. As a result, the trend of eliminating existing pension plans and replacing them with less costly programs has increased. As a physician who owns a professional practice, you may not realize that implementing a class-based pension plan will allow you to both reduce spending and increase benefits to employees.
Class-based pension plans (also known as cross-tested or new comparability plans) group employees in different categories for purposes of determining the amount of employer contributions on behalf of each employee. In small professional practices, a class-based plan can boost tax-efficient contributions to the owners’ retirement plans.
This article identifies some of the key information you need to know to tailor your practice’s retirement plans to meet the needs of you and your employees.
One of the benefits of class-based pension plans is the ability to alter them to meet your specific needs. These plans address many design issues, from lowering the cost of funding to serving the differing needs of owners, managers and rank-and-file employees. In essence, you can create classes in any way you choose, as long as you don’t discriminate in favor of highly compensated employees.
Here are a few examples of different ways to define a class.
In a professional practice – one with two partners, for example – one partner wants to save the maximum tax-sheltered dollars for retirement while the other is more concerned with current cash flow to pay tuition costs for her two children. The answer is a class-based pension plan with each partner in a separate class. This permits the first physician to maximize his retirement savings and the second to elect higher current compensation and a lower retirement plan contribution.
In another practice, consisting of a single physician in his mid-50s with five younger employees, the owner’s primary goal is to maintain flexibility while keeping costs down. The answer: a class-based pension plan with the physician in one class and his employees in the other. This allows the physician to make higher contributions on his own behalf while still providing his employees with retirement benefits.
Major pension providers typically provide cookie-cutter plans under which every participant – owners and employees alike – receives the standard contribution. Class-based plans, especially when there is an age gap between owners and employees, can produce cost savings and enhance flexibility while still providing valuable employee benefits to every level.
Class By Class
Classes for pension purposes can be established in a variety of ways. However, your practice must define the classes in the plan documents. A change in the number or definition of classes requires an amendment to the plan. As an employer, you might group employees born before a certain date, hired after a specific date or with a specified number of years of service. Another grouping might be by department, title or type of job. If you need help fine-tuning the classes to meet your goals, check with your pension advisor.
You can amend plan documents to change the classes, but changes may not be retroactive. There is flexibility after the fact, however, as profit-sharing plans permit you to determine the actual contribution level for each class after the end of the year. You and your pension advisor can evaluate the situation early each year and discuss the most advantageous class groupings for the coming year. If you want the utmost flexibility in defining the classifications, consider a plan design that defines each participant as an individual class. This would mean that a ten-participant plan would have ten classes. You would determine the contribution rate for each class in the same way as if the plan had only three classifications.
Be aware that the IRS or the Department of Labor might consider a plan assigning each employee to a separate class as “deemed 401(k).” This would make the plan subject to the 401(k) deferral limitation as well as actual deferral percentage (ADP) testing if the plan did not meet a safe harbor exception. Some view these multi-class arrangements as very aggressive and recommend waiting to see if the IRS or the Labor Department attack them on audit or in technical guidance before implementing such a design. Again, if you have questions, your pension advisor can provide you with information to make an informed decision.
Federal rules govern pension plans of all types, including class-based pensions. Annual contributions on behalf of any one employee (in 2006) are limited to 100 percent of compensation but no more than $44,000. If the plan has a 401(k) component, up to $15,000 of this $44,000 may be contributed by the employee, with the rest coming from the employer. Employees who will reach age 50 by the end of the plan year may contribute an additional $5,000; this “catch-up” contribution does not count toward the $44,000 total.
Professional Practice Scenario
In the simplest version of a class-based plan, highly compensated employees (such as the partners in a physician’s practice) are in one class, while rank-and-file employees are in a second. In a variation on this theme, there might be three classes: for owners, managers and employees. Or, as noted earlier, professional partners with different goals could each be in a different class, with additional classes for other employees. It’s even possible to establish a plan with each employee in a separate class.
Most small professional practices adopt profit-sharing plans, with or without a 401(k) component permitting employee contributions. The 401(k) component is becoming increasingly popular because it allows older employees to make additional catch-up contributions to build their retirement nest eggs. Some small practices still use money purchase plans (where the annual contribution is defined in the plan document), although profit-sharing plans are more flexible (because contributions are discretionary). With either type of plan, it can be advantageous for businesses to adopt a class-based approach.
While class-based plans work well in many situations, they typically don’t work in companies that:
· Set up their 401(k) plan as an employee benefit and are only matching contributions made by employees.
· Have no non-owner employees and want all owners treated the same.
· Have owners or key employees who are younger than most of the other employees.
A professional practice looking to implement a class-based pension plan must remember the fundamental rule that the plan cannot discriminate in favor of highly compensated employees. Therefore, your pension advisor must continually test to make sure the plan meets IRS anti-discrimination standards. While careful plan design and expert advice are required to establish and administer a class-based plan, the effort is worthwhile in terms of both increased flexibility and lower costs. You can maximize your own contributions while reducing the cost of employee benefits. At the end of the day, class-based plans are an option small companies should explore in an effort to keep costs down without terminating pension coverage.
Mark Papalia, CLU, ChFC, CFP is president and founder of Papalia Financial, an advisory firm in Danville, Pa.