EXECUTIVE
SUMMARY |
CLASS-BASED PENSIONS, WHICH
GROUP EMPLOYEES in different
categories for purposes of determining
employer plan contributions, are one way
companies can reduce pension costs and
increase benefits to key employees. Larger
organizations often use class-based plans
to provide employee incentives or reward
productivity.
COMPANIES CAN DEFINE
CLASSES IN A VARIETY OF WAYS
as long as the structure is
spelled out in the plan document and the
arrangement doesn’t discriminate in
favor of highly compensated employees. A
change in the number or definition of
classes requires an amendment to the
plan. Changes cannot be retroactive.
ALTHOUGH THE LAW ALLOWS
COMPANIES TO PUT EACH
employee in a separate class,
the IRS or the Department of Labor might
object to this arrangement. Some experts
recommend waiting to see if either
authority attacks this alternative on
audit or in technical guidance.
SMALL BUSINESSES SUCH AS
MEDICAL PRACTICES can use
class-based plans to increase
flexibility—for example, when one owner
wants higher retirement plan
contributions and another wants more
current compensation. Larger businesses
also can use them as an incentive by
grouping employees by job title,
division or region.
CLASS-BASED PENSIONS
AREN’T FEASIBLE IN EVERY
situation. They typically don’t
work for companies that have no nonowner
employees and want all owners treated
the same, or where the owners or key
employees are younger than most of the
other workers. | MARK PAPALIA, CLU, ChFC, CFP,
is president and founder of Papalia
Financial, a financial advisory firm in
Danville, Pennsylvania. His e-mail address
is
mpapalia@papaliafinancial.com .
|
n today’s business climate, every
company is exploring opportunities to minimize
benefits costs while still providing value to its
employees. Many are eliminating conventional
pension plans and replacing them with less costly
alternatives. Executives in most small and midsize
organizations are generally unaware that
implementing a class-based pension plan will allow
them to reduce spending while also increasing
benefits to key employees. Particularly when there
is an age gap between owners and employees,
class-based plans can save money, enhance
flexibility and still provide valuable benefits to
rank-and-file workers. 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 contributions employers make on behalf of each
employee. Larger organizations often use
class-based plans to reward productivity and
provide employee incentives. In small professional
practices, a class-based plan can boost
tax-efficient contributions on the owners’ behalf.
Either way, CPAs can recommend a company customize
class-based pensions to fit the needs and
objectives of its specific business.
Class-based pension plans group
employees in different categories for
purposes of determining the amount of
contributions employers make on behalf
of each employee.
|
This article identifies some key information
CPAs—in their capacity as CFOs, human resources
professionals, financial managers or
consultants—need to advise companies about their
retirement plan alternatives. Staff CPAs in larger
companies can offer important advice about
tailoring retirement plans to provide employee
incentives. CPAs in public practice can do the
same to help smaller companies and professional
practices meet the sometimes contradictory needs
of owners and employees. While businesses
generally employ pension specialists to implement
these plans, CPAs can use the information in this
article to help a company decide whether a
class-based plan is a feasible alternative.
SMALL COMPANY SCENARIO
In the simplest
version of a class-based plan, highly compensated
employees (such as the partners in a medical
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, professional partners
with different goals could each be in a different
class with additional classes for other employees.
Small businesses can even establish a plan with
each employee in a separate class. A
simple example illustrates how class-based plans
work, as well as the potential cost savings—and
the benefits for employers—compared with a
traditional plan. Consider a professional
practice with two owners, each drawing an annual
income of $205,000; their spouses, each earning
$20,000; and nine employees with annual salaries
ranging from $22,000 to $60,000. Most of the
rank-and-file employees are considerably younger
than the owners. Here are the possible cost
differentials, based on contributions, CPAs can
calculate for adopting various plans:
In a traditional profit-sharing plan,
with the contribution for each participant capped
at 20% of compensation to a maximum of $42,000 in
2005, annual employer contributions on behalf of
rank-and-file employees total $66,400.
Using a contribution formula that is
integrated with Social Security, percent-of-pay
contributions for the rank and file drop to
17.03%, reducing employer contributions to
$56,539.
Using a class-based plan with one
class for the owners and another for all
rank-and-file employees, converting contributions
to the benefits they will produce at age 65 allows
the owners to contribute 5% of pay for the rank
and file, resulting in an employer contribution of
$16,600.
Adding a 401(k) component to the
previous examples, whereby employees are
responsible for making a portion of the allowable
contributions on their own behalf, reduces the
employer contribution to 4.55% of pay, or $15,106,
for the rank and file. The 401(k) option also
would allow owners over age 50 to make a total
combined contribution of $44,000 because of
employee catch-up contributions. There are
other possible variations on this theme. The
practice could create more categories. One of the
two owners might opt out of the pension plan
altogether for personal reasons. The only
hard-and-fast rule, as noted earlier, is that the
plans may not discriminate in favor of highly
compensated employees. For any plan year a
highly compensated employee is defined
as any owner or employee who meets one of these
criteria under IRC section 414(q)(1)(C):
Is a greater than 5% owner at any
time during the plan year or the preceding plan
year.
Earned more than $95,000 in the
preceding plan year ($90,000 in 2004) and was in
the top-paid group of employees for the preceding
year.
The High Cost of Pensions
In a survey of employers,
69% cited the impact of pension costs,
volatile investment markets and regulatory
compliance as extremely or moderately
important concerns. To help solve the
problems, they were considering these
strategies:
Source: The Segal
Group,
www.segalco.com .
|
TAILORED PLANS
One of the advantages
of a class-based pension plan is that companies
can alter it to meet their 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.
Multiple-class plans allow owners to reward
productive employees without increasing costs for
all employees. A company can do this by
establishing separate classes for offices in
different locations with different productivity
levels and revenue streams. Employers can create
classes in any way they choose as long as they
don’t discriminate in favor of highly compensated
employees. For example, in a privately
held manufacturing company with 230 employees, the
owners want to provide performance incentives. The
CFO suggests dividing the staff according to job
description and regional location, establishing
nine classes based on differing levels of
productivity to determine profit-sharing
contributions. While in this instance total
employer contributions to the plan are identical
to those made under a standard arrangement,
dividing the employees into different classes
allows the company to reward certain workers.
In another example, a medical practice with two
partners, one partner wants to amass 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
group’s CPA recommends a class-based pension plan
with each partner in a separate class. This allows
the first doctor to maximize her retirement
savings. The second can elect higher current
compensation and a lower retirement plan
contribution. In another medical practice,
consisting of a single doctor in his mid-50s with
five younger employees, the owner’s primary goal
is to keep costs down. The answer: a two-class
plan, with the physician in one class and his
employees in the other, allowing the doctor to
make higher contributions on his own behalf while
reducing the cost of providing retirement benefits
to his employees. Federal rules govern
retirement plans of all types, including
class-based plans. For 2005, annual contributions
on behalf of any one employee are limited to 100%
of his or her compensation to a maximum of
$42,000. If the plan has a 401(k) component, up to
$13,000 of this amount 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 $3,000;
this “catch-up” contribution does not count toward
the $42,000 total. 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. Profit-sharing plans are more
flexible because contributions are discretionary.
Either way, adopting a class-based approach can be
advantageous. Most large, publicly traded
corporations do not use class-based pension plans,
in part because of increased shareholder demands
for transparency. They rely instead on other
programs to provide employee incentives. Midsize
entities, many of which aren’t publicly traded,
typically have solid business reasons to give
certain workers incentives. Class-based pensions
allow them to do this in the form of larger
retirement plan contributions. AICPA
RESOURCES |
CPE
Qualified Benefit Plans:
Taxation and Administration for Small to
Mid-Sized Companies (# 731900JA).
Practical ideas about designing and
funding benefits packages.
Qualified Retirement
Plans—401(k), Keogh, SEP, SIMPLE… Does
Your Plan Still Meet Your Needs (#
731870JA). How to help small businesses
select the right retirement plan.
Conference AICPA
Employee Benefits Conference May
16–18, 2005 Bellagio Hotel, Las
Vegas. For more information or
to order visit
www.cpa2biz.com or call
1-888-777-7077.
|
CLASS BY CLASS
Companies can
establish classes for pension purposes in a
variety of ways. However, they must define the
classes in the plan documents. A change in the
number or definition of classes requires an
amendment to the plan. An employer might group
employees born before a certain date or hired
after a specific date or with a specified number
of years of service, by department or title, by
type of job or by regional location. CPAs can help
employers fine-tune the classes to meet their
goals. Since many variations of the class-based
approach are possible, CPAs should recommend
companies bring in a pension specialist to help
them carefully weigh all possible options.
A company can amend plan documents to redefine
the classes, but changes may not be retroactive.
There is flexibility after the fact, however, as
profit-sharing plans permit owners to determine
the actual contribution level for each class after
the end of the year. CPAs can evaluate the
situation early each year and suggest the most
advantageous class groupings for the coming year.
Employers wanting the utmost flexibility in
defining the classifications might consider a plan
that puts each participant in an individual class.
This would mean a 30-participant plan would have
30 classes. The employer would determine the
contribution rate for each class in the same way
it would if the plan had only three
classifications. However, CPAs who
recommend employers or clients assign each
employee to a separate class should be aware the
IRS or the Department of Labor might consider such
a plan a “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 plans with each employee in a separate class
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.
BIG COMPANY SCENARIO
Although total
contributions for large companies under a
class-based plan might not change, as they did for
the smaller entities described earlier, these
businesses can use this pension option to
accomplish other objectives. For example, under a
standard profit-sharing arrangement, the
230-employee company described earlier would
contribute a total of $793,340; using a
class-based plan, with nine classes, the CPA in
charge of human resources would find the total
contribution is the same but the allocation would
be very different. In the class-based plan
the company adopts, 25% of compensation is
allocated to profit-sharing contributions for the
six owners, 15% to the human resources staff and
10% each to nonsales managers and administration.
Sales managers receive 8% of compensation while
sales associates and office staff, divided by the
region they work in, receive contributions ranging
from 5% to 8%. The allocations can change from
year to year. With 25% of compensation
allocated to the top class, contributions for the
six owners would be $225,000 or 28.5% of total
company contributions. Compare this to the
standard arrangement where the total contributions
for these six people would be $90,380 or just
11.455% of the total. While the owners
come out ahead under this particular allocation,
so do some other classes of employees. The human
resources staff and nonsales managers also have a
larger sum contributed on their behalf, as do
sales associates in the eastern region. However,
the western sales associates—with lower
productivity for the year—fare less well. Office
employees also get less than under a standard
profit-sharing plan.
OTHER CONSIDERATIONS
Companies large or
small seeking to implement a class-based pension
plan must remember the fundamental rule that the
plan cannot discriminate in favor of highly
compensated employees. CPAs must continually test
to make sure the plan meets this IRS
antidiscrimination standard. While
class-based plans work well in many situations,
they typically don’t work for companies that have
Set up their 401(k) plans as an
employee benefit and are only matching
contributions made by employees.
No nonowner employees and want all
owners treated the same.
Owners or key employees who are
younger than most of the other employees.
Companies evaluating class-based pensions as a
way to provide incentives should remember that
because they must specify the classes in the plan
document at the beginning of the plan year, the
incentives will trail performance by a year. This
might cause some organizations to select other
ways to motivate employees more immediately.
STEP BY STEP
While careful plan
design and expert advice from pension consultants
are required to establish and administer a
class-based plan, the effort is generally
worthwhile in terms of both increased flexibility
and lower costs. Professionals in small practices
can maximize their own contributions while
reducing the cost of employee benefits. Larger
companies can maximize employee benefits while
rewarding productivity. For companies that might
otherwise terminate coverage altogether due to
high costs, class-based plans are an option
companies of all sizes should explore. CPAs can
use the information in this article to help
companies through the exploratory stage to see if
it is worthwhile to call in a pension expert to
take the next step on the road to implementing a
class-based plan. |