The greatest thing since sliced bread? The cash balance pension plan. Everyone understands quantum physics. Protect your assets. People don’t do what they should. I have a house in Nevada and Boca Raton. I own a bunch of cars. I’m Jay Leno. Live within your means. Chasing high income from wages is foolish.

Welcome to our listener-supported podcast, Money Talk, uncompromised absolute financial truths behind financial perceptions with host, Ed Sutkowski and Chuck LeFebvre. Let’s listen in.

Ed Sutkowski: Welcome, I’m Ed.

Chuck LeFebvre: And I’m Chuck.

Ed: Today’s topic, the cash-balance pension plan, which is a species of a defined-benefit plan, but it’s really a hybrid. It’s a cross between a defined-contribution plan and a defined-benefit plan. The same eligibility, a little different vesting requirements are in place, non-discrimination as to contributions and the allocation, no investment direction by a plan participant. Same distribution limits designed to secure a life-only annuity of $225,000 a year, cut back if you have less than 10 years of participation. Typically, in the pension plan, no lump-sum distribution, and some limitations on how much can be taken out in a lump sum. Bottom line, in the case of a defined-benefit plan and a cash-balance plan, you have to get to a pot of approximately $2,852,960 designed or required to produce an annual, lifetime benefit of $225,000, beginning at your age 62. Chuck, let’s talk about the hybrid nature of this plan.

Chuck: Yes. If you’re familiar, which I think most of our listeners are, with quantum physics, then this is going to make perfect sense to you [laughter] because just like light can be both a particle and a wave at the same time, these cash-balance pension plans are, in some ways, defined-benefit plans, and, simultaneously, in some ways, defined-contribution plans. Let me unwrap that a little bit. This is my own personal heuristic about how to think about this, I think, the most clearly. Ed, you can jump in and tell me where I get some of this wrong if I do. The way I think about it is, think about just your basic defined-benefit plan where what you’re going to say to your employee is, ”I am going to give you a benefit of so much percent per year of your salary upon retirement, and that will come to you in the form of an annuity. I.e., an annual payment that goes to you each year between the day you retire, with a presumptive retirement date [sic] of age 62, and your death.” You start by saying, ”I’m going to give you that benefit.” Now, an actuary will show up and do calculations, and say, ”Okay, in order to give your employee Ed that particular benefit, here’s how much you have to contribute to a trust in order to make sure that upon his retirement, he will have that particular benefit to him.” During the accumulation phase of this plan, it’s behaving very much like a traditional, straightforward defined-benefit plan, but when it comes time for Ed to really get his benefit, we say, “Well, Ed, here’s how much has been accumulated in this plan, on your behalf, and so, you have a cash balance that you can now roll-over into an IRA and reinvest however you want, and take lump-sum distributions or take an annuity, or whatever you want to take out of this thing.” Suddenly, this thing that was designed and funded on the theory of being a defined-benefit plan just flips over and it behaves like a defined-contribution plan when it comes time for the employee to actually receive the payout.

Ed: Yes. The hybrid approach is a little different. Specifically, the cash-balance plan, remember, is really a defined-benefit plan that’s in that separate cell, relates to that, and while you’re funding for this hypothetical annuity– annual payment of 225 a year beginning at age 62, the trust creates a separate, hypothetical– not a real, but a bookkeeping entry, hypothetical account for you, and the plan credits interest to that hypothetical account ranging from 5% to 8% a year. And the sum of your hypothetical account, plus interest, is the amount of your benefit expressed in such a fashion as those that your account balance with interest will yield this hypothetical annuity of 225 a year.

Chuck: See, that’s as clear as it can be. [laughs]

Ed: That’s right, there’s nothing to it. Having said that, in the case of a profit-sharing plan, you may withdraw your account balance, if the plan allows it, after a fixed number of years. In the case of a pension plan, including the cash-balance plan, at age 62, you can withdraw the single sum value of those hypothetical accounts in a lump sum and transfer it directly to an IRA, and not be constrained. The bottom line here is you can determine the amount set aside by the employer, by reference to your hypothetical account, plus interest. If the plan doesn’t make that, guess who’s responsible for it? The employer, and if it makes more, guess who gets the benefit? The employer because the contributions need to be reduced. It is– and in my world, an extremely positive approach for the right kind of employer. For example, let’s assume that your total compensation package is about $125,000. If the plan provides this, your W2 can be reduced to $50,000– Remember, you’re age 50 at $50,000, and the total contribution set aside for your benefit is about $75,000. Your total package is still 125,000 but 75,000 is set aside, and you forever save about 25% of that $75,000. And when you hit 62, you can take that out directly from the plan and trust to your individual IRA, even if you’re still employed by the sub-employer. Putting it another way, you can accumulate– currently, at your age 62, a pot of 2,852,000-plus, and yet, you can take that pot out at 62 and send it to your IRA. Now, the greatest application for this isn’t necessarily in the large-employer plan. You’re not going to see a cash-balance plan with a listed company, a large employer. You’re going to see a cash-balance plan, typically, with licensed professionals. Chuck, have you seen those guys?

Chuck: Yes. They are definitely some of the people who can benefit the most and seem to have the type of business that’s very well suited for this type of plan because they are, characteristically– and I always think of this, the stereotypical person in this category as a physicians’ group, as an example, where you may have a small number of physicians that are practicing together, but it could be accountants, it could be attorneys, it could be financial planners. It could be anybody where what they’re doing is this small group of professionals has a fairly high income. Then, also what tends to help in terms of being able to maximize the contributions is if they’re a little bit up in the years, as well. What you see with these licensed professionals is that, yes, their careers typically start a little bit later, and then, they’re earning a high income, and they have control over the company that also employs them. And so, they are in the role of both employer and employee in this situation. Like you said before, Ed, if the investments in the plan underperform the anticipated investment rate, the employer has to pony-up that extra money, and that’s for the benefit of the employee. If the plan over-performs, then the employer benefits from that extra performance. The best person or the best company to be setting this up is one where the employer and the employee, it’s the same group of people who represent both. Yes, licensed professionals are ideal in a situation like this, and we see this in your hypothetical. You were talking about somebody who had a total income, coming from employment, of $125,000 per year. With some of these licensed professionals, you’ll see people where their annual earnings from practicing medicine– and some lawyers will be in this category and so forth, where you might be talking to people where they have $750,000 in annual income. In those cases, they have the opportunity to– Let’s say, in that situation, it’s a 60-year-old who’s practicing medicine and making $750,000 a year in what would, otherwise, be a salary. That particular person would have the ability to contribute to this plan, or the employer would contribute to this plan on behalf of that person, nearly $260,000 for the benefit of that particular physician, which is just– We’re talking about several multiples of what the maximum amount is that could be placed into a defined-contribution plan for that particular person. One of the reasons why this is so well-suited for that type of employer, that type of business, is because you are dealing with people where it’s a small group with fairly high incomes. The other reason is, quite often, these are the same people that are always worried about asset protection. They’re worried about being sued, they want to set aside some of their assets so that if there’s ever a malpractice suit or something like that, they’ll be protected. And again, because this is an employer-sponsored retirement plan, it gets special protection, and that fund is then off-limit [sic] to creditors.

Ed: Plus, the era that’s distributed is– that receives the lump sum benefit is 62. That’s off-limits, too.

Chuck: That’s exactly right. This provides a dual function. One of which is substantial tax savings and the other is asset protection.

Ed: Let me give you the best example that I’ve seen over the five decades of messing around on this area, is let’s say you have a group of highly-compensated professionals with long-term, common-law staff people, and they’re making a fair amount of money. What can occur is you can have an arrangement outside the plan, [incident? 00:12:54] to which each highly-compensated employee has a pot of, let’s say, $500,000. And you can design the cash-balance plan formula to permit the total compensation to be allocated between W2 and plan-contributions such that the total pretax emulates the agreed-upon pot. Well, what you can do in the case of a licensed professional where there may be some goodwill associated with that– and that, frankly, in the case of a licensed professional, I see very little goodwill. It’s in the eyes of the beholder, but it doesn’t really exist. Once your patients or contracts are gone, the organization has no sustained value. Having said that, so what can occur? Let’s assume that an older professional employee was taking out $300,000 and has a benefits program in place funded by the organization that’s designed to produce, to this older employee, X-number of dollars per year– say $100,000 for life. Saddling this benefit on the employer, but in lieu of that, a cash-balance plan is established. $150,000 goes to the older employee and W2, and the balance into the cash-balance plan sets that, after 10 years of plan participation, this older employer has this 2,800,000, almost 2,900,000, in a lump sum. That relieves the pressure on the organization to pay the departing, older employee anything, and so, you facilitate the exit and entry of younger professionals into the organization. That may be difficult to conceptualize, but then, also, if there’s a shortfall or a benefit, the compensation for the next year is adjusted to reflect the employers’ increased or decreased contributions. In other words, you can use the cash-balance plan in combination with W2 compensation to achieve an enormous result. The downside, guess what? They don’t do it. I bet I’ve talked to 100 organizations over the last 30 years, and without a doubt, maybe 3% will establish it, and I’ve got no skin in the game. We don’t draft these anymore given they’re all near our commodity, we send them to an enrolled actuary. I have no skin in the game in terms of professional fees, and yet, the individual licensed professionals will not do it. Why? ”Well, I’ve got this house in Nevada. I’ve got a place in Boca Raton, Florida. I’ve got a collection of cars, I’m Jay Leno,” and they’d simply had no disposable cash to set aside. Your experience or mine–? Am I wacky? Or daffy? Or what’s going on?

Chuck: No, you’re not daffy. I think that this gets to one of those fundamental concepts that we notice in our practice with respect to– Really, what this whole series of podcasts is about is the secrets– They’re really not well-kept secrets, but they tend to be secrets nevertheless, the secrets of accumulating real wealth. One of those that we mentioned, early on in this series of podcasts, was the fact that so many people chase high income from employment. And you’ve described exactly what happens here, Ed, which is that people who are in that situation, they end up spending every penny that they make, or at least they think that they’re spending every penny they make because when you sit down and you talk about the opportunity to divert large percentages of that salary into a tax-deferred arrangement like this, which involves incredible tax savings, they suddenly have all of these financial obligations that prevent them from feeling comfortable doing that. That is the psychological trick here, which is that what we’ve been saying, pretty much from the very start of this whole series of conversations, is that part of the trick to accumulating wealth is living within your means, and to make sure that you are really interested in saving this money. The other part is understanding that chasing that high income from wages is a fool’s errand in the sense that you are paying the highest possible rate of tax on that money. And when you divert it into a cash-balance plan or any other type of tax-deferred arrangement, then a substantial portion of that contribution is, in effect, being made by the Federal government in the form of tax savings because you’re not paying tax on that money as it goes into the plan. I think people have a very hard time mapping that out in their minds when they’re presented with this opportunity because they’re used to this money slipping through their fingers very quickly and they lose track of the fact that a pretty large percentage of that money is actually slipping through their fingers in the form of tax, which will not have to be paid once you establish a plan like this. That’s one of the first problems with this. The second is because it is such a complicated plan, it makes it that much harder for people to really put together a budget, so to speak, for, ”Okay, tell me what next year is going to look like. How much am I going to take home? And how much is going to go in this plan? And what’s that going to look five years from now or 10 years from now?” Quite often, they can envision the very next year, but they are very nervous about what that means a few years down the road, and whether they’ll continue to be able to afford it because so much depends on these actuarial calculations. It takes a little bit of a leap of faith, confidence in one’s self– in one’s ability to live within the means and one’s ability to continue to have a profitable medical practice, law practice, accounting practice or whatever type of practice it is, and the ability to recognize the incredible potential that’s embedded in having the tax-deferred and some portion of the tax completely not paid once it goes into this particular plan.

Ed: A couple of observations, philosophical or psychological. In visiting with entrepreneurs and licensed professionals, I look at a threshold– if your organization has fewer than 101. In other words, not to exceed 100 employees, a cash-balance arrangement is in the cards for you. It can work. Having said that, the downside is that entrepreneurs, licensed professionals tend not to defer self-gratification, especially the lawyers and doctors. Not the actuaries, not the accountants, but the lawyers and doctors said, “Look, I have a useful– a limited, useful economic lifetime. I’m going to get worn out if I can’t do this. I haven’t started the profession until I’ve completed all of my education, it’s a highly competitive environment. I’ve had malpractice threats and the like, and so, I’m going to spend this down because I haven’t the slightest idea where this is going. I can be a ghost in one year, and so, I’m going to dissipate these assets.” What I’ve said to these individuals, male or female, ”Here’s what you do. You go ahead, and with your business organization, all you highly-compensated people take no salary out until December 15th of the calendar year.” ”Well, how do I live on–?” ”You borrow the money.” What does that do? It’s an automatic constraint or it governs the disposition of those assets. You’re not going to buy a house, you’re not going to buy multiple cars. You’re going to budget, if you will, knowing at the end of the year, you’re going to receive a distribution, but you’re, in the meantime, then, going to have a pot available at the end of the year to fund the cash-balance profits plan, except by– but guess what? Doesn’t happen. [chuckles] It’s like I’m daffy telling an individual to do that. The deferral of self-gratification goes against the ideas of these tax-qualified arrangements. People want the cash, they want cars, make all the investments, but the opportunities to realize on a lifetime of enjoyment and facilitate marital dissolutions– facilitate everything is they refuse to go and move forward with deferring self-gratification. Your experience?

Chuck: That’s exactly my experience. As the years go by, it’s actually more and more of a shame in the sense that, as you’d mentioned earlier, establishing these types of plans, it’s becoming more and more of a commodity business, which means that the friction costs associated with establishing a highly sophisticated plan, like a cash-balance plan, is remarkably low. If you were to roll back the clock a few decades, it would be a major investment to design, implement and create a plan like this. Now, we’re talking about, on the front end, spending a few thousand dollars and you have a plan up and running that’s customized, and then, a fraction of that, each year, going forward. The friction costs on these things are relatively low. It really is just a matter of deciding that you’re willing to do it. You mentioned another issue that is also, I think, key, here, which is people just have a tremendous discomfort with the idea of borrowing. And again, getting back to original principles here, the first that we’ll probably keep hitting on, over and over again, is that, first of all, not to seek wealth through chasing higher and higher W2 income. Number two, deferring self-gratification and living within your means. Number three is being comfortable with the right type of borrowing. This would be an example of the right type of borrowing when you referred to– We’ve really backed into, inadvertently, two different forms of it, in our conversation today, one of which is what you mentioned. For someone who’s a business owner, don’t take a salary throughout the year. Wait until December 15th and then, take a salary at the end of the year. Then, you can divide up the pot according to what’s going to go into various arrangements, versus what’s going to go into a W2, versus what might come out as a profit distribution from the company that you’ve created, that you’re practicing or working under. There’s a second type of borrowing that we hinted at and didn’t really mention– The borrowing in that scenario is, if you need money to live off throughout the year, that’s borrowed money. The second type of borrowing that we glanced at is the sense of, ”Boy, if I established a cash-balance pension plan this year, what happens if, three years from now, I have a bad year, and suddenly, it becomes very difficult to be able to fund that plan?” There, again, someone going into one of these things has to be comfortable with the concept that, yes, you may just need to borrow money when– Just as the business cycle causes deviations in the economic performance of your business, if your long-term prospect is positive and you’re confident in that, then that’s, again, an example where the right type of borrowing is appropriate. Boy, I’ll tell you what, whether they say it out loud or not, that’s a major hurdle for many people.

Ed: I recognize that. I’m a little surprised because there isn’t, necessarily, the optimum solution to the sunset time of your life, but by way of fraud or summary, [sic] that those of the listeners that are merely W2 people– and I say ‘merely’, that’s not fair. You can be a– that you’re a human being. If you happen to be employed by a major organization, then you don’t have this flexibility and distributions that you might, otherwise, have if you owned the business organization. There, when you’re talking about W2 employees, you’re talking about maximizing contributions to your 401k plan, and being careful with an ESOP if your organization has that. In other words, defer self-gratification. Now, let’s assume you’re employed by an entrepreneur. Well, you can act like an entrepreneur, and with, let’s assume, not more than 100 employees, defer self-gratification. Borrow money out to live on, and at the end of the year, December 15th, you’re going to get your bonus, and pay back the loan so, at the end of the year, you’re not going to have any debt associated with this living– but you’ve got the opportunity, then, to put as much money away as you can into one or more of these tax-qualified arrangements, or a combination of– More importantly– and, perhaps, most importantly, is the transition planning for an organization where there’s, really, limited goodwill, and, historically, that goodwill was satisfied by way of a burden on the employer to fund a retirement benefit with a non-qualified, deferred comp arrangement. In other words, you take your receivables out, your work-in-process and a goodwill feature out, and the burden of the payment remains on the part of the organization, versus– remember, with this pot approach, you’re, annually, so to speak, within the limits– bust up this pot between W2 compensation and plan contributions, and fund, if you will, the exiting of the founders at a nominal cost to those that remain– nominal, if any cost, of those that remain. That attracts a relationship that will subsist as long as the organization subsists. Don’t sell the organization with a pension payment, if you will, that is not from a tax-qualified arrangement, and the opportunities are fantastic. Three classes. The W2 employee with limited opportunities. Number two, the employee with an entrepreneur. Number three,the entrepreneur himself, and within that same category is the transition-planning for licensed professionals. Talk all you want about this, but guess what? It typically doesn’t work. [chuckles] That’s not going to stop me from continuing to urge that. And some see the merits of this, and, always, they ask me, “What’s in it for you?” And I have to say, “Well, nothing. I’m charging you an hourly fee for this advice. If you don’t take it, that’s fine. I’m going on to the next person, and I sleep well at night.” Chuck, observations?

Chuck: Well, I’ve got to push back, a little bit, on your comment that it doesn’t work. What you mean by that, I think, is that people just won’t take the leap.

Ed: That’s right.

Chuck: But when these have been put into place– at least the times that I’ve observed it, they actually have worked pretty well. I don’t really have a lot of experience with people putting in place a plan like this and then, later, regretting it. They tend to be very glad that they did it. In fact, some people are just ecstatic about– when you look, now, at some people who did this decades ago. We’re talking about having savings that are embedded in an IRA that are just astonishing, and really, could not have been accumulated any other way.

Ed: And, by the way, it doesn’t change their lifestyle. These individuals with these huge IRAs, they’re still doing what they enjoy the most. They may still be working, they’re pursuing their passion. They have enough set-aside, they don’t have to worry about the next paycheck. It allows them to pursue their passion, or if it’s not– after they’re terminated, are collecting boats, going to seminars or going on a cruise– Whatever it is, but they have the financial flexibility. If they’re careful about the investments– and we’ll get into the cost-managing investments on another podcast, but we’re just demonstrating, on the accumulation stage, how you set it aside. The difference between ordinary income distributions of tax-qualified arrangements and long-term capital gain income, taxes are a feature, and our podcasts really are urging the participants, the listeners, to think about, what’s the long view? And what’s best for them.

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