Money Talk

Episode 11

Defined Benefit Plan

Avoid income tax on over $300,000 of earned income. The best kept secret of the tax code. The old-fashioned pension plan. Politicians keeping numbers under wraps.  Too much confusion. The best thing since sliced bread revealed on the next episode.

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.

Chuck LeFebvre: I’m Chuck.

Ed Sutkowski: I’m Ed.

Chuck: Today we’re going to talk about something that’s fairly exciting. We don’t normally do teasers at the beginning of our episodes, but I’m going to tease you this time because what we’re going to talk about specifically is how you can avoid income tax on over $300,000 worth of earned income in a particular year. This is one of the best-kept secrets of the tax code as far as I’m concerned. Specifically, we’re talking about the accumulation phase and defined benefit plans, particularly a particular type of defined benefit plan called the cash balance pension plan. This is an interesting plan that bridges the gap between the defined contribution plans and trusts of the type that we have discussed on prior episodes, and a defined pension plan or a defined benefit plan, which is the other major category of retirement plans or employer-sponsored retirement plans. Now, what characterizes a defined benefit plan is just as its name implies. It’s a plan where the definition of what an employee can expect to get out of the plan upon retirement is not based on the amount of contribution that was made to the plan by the employee or by the employer on the employee’s behalf, but it’s a formula that specifies what that employee can expect to receive in retirement income following retirement from the plan. This is the old-fashioned pension plan from way back before everybody had 401(k)s. This is like social security. This is where, in the general category of a defined benefit plan you’re talking about, a plan that typically is defined as something like you’ll get 3% of your salary for each year that you work here based on the average of your last three years of earnings that you’re working for the company. That’s a defined benefit plan. You don’t have any idea how much money is actually going into the plan on your behalf, but you know what you’re going to get out. These types of plans are just like the defined contribution plans. They can have eligibility requirements in terms of you need to work a certain number of hours per year. You need to work at the employer for a certain number of years, investing requirements, and so forth, non-discrimination requirements. They’re structured in such a way that, typically, the benefit that you can receive is set on some type of a formula. The cash balance pension plan, Ed, is something that takes that concept and just flips it right back around, right?

Ed: Yes. Before we address the benefits of that plan and, remember, in all these instances, the employers required to cover a certain number of employees with comparable benefits that are non-discriminatory. These are all very important characteristics, terrific opportunities, but know that you got to bring along people and be careful before you jump at it. Make sure you look at the cost to maintain these arrangements for employees. I’d like to address the downside of these defined benefit plans. You’re being promised an annual benefit. Currently, that maximum annual benefit is $225,000 a year beginning at age 62. There’s no provision for a lump sum. If you have a surviving spouse, there can be life only with a 50% survivor annuity, life only with 100% survivor annuity. Another way, all the benefits are actually equivalent to this life only at 225 a year subject to cost-of-living adjustments beginning at age 62. In other words, as you pointed out, Chuck, think social security. The risk of funding that is on the shoulders of the employer. The employee has nothing, no skin in the game. However, think about the application to government-sponsored plans. The problems we’re having in the public sector relate to the funding of these historical defined benefit plans. Why? People are living longer. If it’s a life annuity, it’s going to last a longer time. Second, the amount of investment return, that isn’t necessarily going to be the very best over a long period of time. Maybe 3% or 4%. If the returns are not sufficient to fund the benefit, then the employer has to make it up or let’s assume the employer goes bankrupt. Where do you go? In the public sector, people talk about teachers’ W2 compensation without regard to the funding of the retirement benefit, which is a defined benefits arrangement. When you analyze a total package of a government employee versus a private sector employee, you’ve got to factor in the defined benefit pension plan, annual benefit, which is fully vested at age 62 and is cast in stone. The total package is extremely large and perhaps isn’t really measured because it’s hidden and you’re willing to pay, willing to do whatever as long as you can’t see the cost. Is that fair?

Chuck: Well, it’s fair. The other thing is that for a particular employee in a situation like that, typically, the employer doesn’t really know exactly what is being contributed on behalf of a particular employee. Let’s say I’m a government entity and I’ve got, let’s say, 50,000 employees that are working for my branch of the government or my agency and I know how much I have to contribute to this pension plan in total. It’s based on the population, but it’s pretty hard for me to get the numbers as to how much am I contributing for Ed. Typically, you’re looking at this on a population basis. Of course, the employees themselves have no idea what’s really being contributed on their behalf. The reason why this number gets lost in the discussion about what total compensation is, is not because anyone’s deliberately trying to conceal it, although there may be, at least on the part of certain politicians, a desire to keep some of this information somewhat under wraps. It really is not very accessible even to the people who have the greatest need to know what that information is. It’s hard to put a number on it, but it is important. Now, in the private sector, of course, employers do look very carefully at the cost of these plans. The cost of these plans is one of the reasons why you see so few of them in the private sector anymore. Because outside of union contracts and union employees, it’s become really quite an unusual situation to see any kind of employer that is providing contributions anymore to any type of defined benefit plan. It’s because most of these employers understand. When they hire consultants to talk to them about putting a plan together, one of the first things they learn is, “Hey, once you put this plan together, your obligation to make contributions to the plan is going to be based on mathematical calculations that are done on an annual basis.” You really can’t exercise a lot of discretion. In year 10 of this plan, you’re going to get a number from your actuary. This is how much you have to contribute. You have to come up with that money somehow and you don’t get to play with it. That’s a frightening prospect for employers to be looking forward to. They tend to just avoid having these plans altogether. It’s ironic, isn’t it, Ed? That is the result of ERISA being passed. Nowadays, we think of ERISA as having to do with health insurance plans and our 401(k)s and all these other things. The impetus behind ERISA was to make these defined benefit plans financially stable. Once that got legislated where employers had to make these financially stable, they decided, “Wait a minute. We just don’t want to have anything to do with them more or less.”

Ed: The employer can’t really measure the ongoing costs because of employee turnover or interest rates, forfeitures, and relying upon enrolled actuary. By the way, in terms of the friction costs associated with these various arrangements, the simple is the easiest. Money goes into an IRA. You never see any more of it. No compliance, nothing. You go to the profit-sharing plan fairly straightforward. You go to a 401(k) plan. A little more complicated because of the annual update and the annual testing that’s required. You go to the ESOP and the value with issues then you go to the defined benefit pension plan. There, you’ve got an actuary telling you what’s to be said in the plan. You have no control over employee turnover, deaths or disabilities, and yet no control over the investment performance. You get all the friction costs. You got the lawyers. You got the accounts. You have an enrolled actuary. It was a separate set of fiduciary obligations. I have to make certain reports every year. It’s an absolute fiasco. That’s overseeing. It’s a jungle, very complicated to get to the result of these defined benefit plans, which is why we are seeing an enormous changing of the balance between defined benefit and defined contribution plans. They’re too difficult. But in the case of cash balance plan in a special situation, a limited number of employees are highly compensated. The cash balance plan could very well be the greatest thing since sliced bread. Let’s talk about that in more detail next time.

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