Class-Based Pensions

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.

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.

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.

PRACTICAL TIPS TO REMEMBER

Recommend large organizations use class-based pension plans to reward productivity and provide incentives for employees. Small professional practices can use class-based plans to boost tax-efficient contributions for the owners’ retirement. In a professional practice where partners have conflicting needs, suggest the parties explore a class-based pension plan as a way to reconcile differing objectives in a single plan. Make clients or employers aware that assigning each employee to a separate class might invite extra scrutiny from the IRS or Department of Labor. Steer clear of recommending class-based plans to companies that have no nonowner employees and want all owners treated the same or where owners or key employees are younger than most of the other employees.

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.