Money Talk

Episode 09

Defined Contribution Plans

Ed and Chuck differentiate between the various qualified arrangements. IRA’s SEP IRA’s Conversations from 20 years ago. 401(k) Defer as much as you possibly can. We are not looking to scratch anyone’s back. “Ed you are an obnoxious SOB but your results aren’t too bad”.

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: Hello, I’m Chuck.

 Ed Sutkowski:  I’m Ed.

Chuck: Welcome to My Piggie Bank. Today, we’re continuing to talk about the accumulation phase, and specifically, as an addition to our last podcast, where we were talking about qualified arrangements. We’re going to drill down a little bit more today and talk about defined contribution plans, an overview. When we talk about these defined contribution plans, they really fall into two categories. The first of those categories, which is really the most familiar I think for most people, is what we would refer to as a non-trust arrangement. What that means is that we’re talking about an arrangement that is deferred from income tax, and contributions are deductible on your tax return, but do not involve a trust that’s created by an employer. The most obvious example of this is the lowly IRA, which is a custodial arrangement that can be opened up at a bank or any investment firm. It’s an individual account that you put your own money into, after you’ve already received it. You do have to have earned income in order to participate in an IRA. Then there are contribution limits to what you can add to that account, but once the money is in there, it can grow to any amount under the sun that you happen to be able to allow it to grow to. IRAs sometimes end up becoming quite large, because they receive money that’s rolled out of one of these other trust-based plans. That’s the starting point is talking about the IRA, and I think most people are fairly familiar with that. Another example is a simple account, sometimes referred to as a simple IRA, and a simple plan works a lot like an IRA. In fact, it’s kind of a form of an IRA, only here, you’re talking about something that is set up with an employer, where the employee is able to defer income into that account. In this case, the amount that you’re allowed to defer into it is slightly higher, so you can defer up to $13,000 of income directly out of, what would otherwise be W-2 earnings, into this individual account. Again, other than that, it works the same way. It grows, tax-free, and you own the as the individual owner. Then, the third which is a little more complicated but again, is a individual type account is the SEP IRA. Here you’re talking about a plan that, again is an individual account that can be funded, not only with deferrals, but also from employer contributions, and so the limits for the contributions are much more like when you get into a full employer-sponsored, trust-based plan. These are examples of ways. These are the simplest and the easiest to understand examples of deferred contribution plans where the individual account owner is in absolute control over what happens to that money after it goes in there. It’s an individual account that the individual account owner can make all of the decisions about what happens in that account once the funds are in there, subject of course, to the tax rules. Now, that’s in contrast to what most people experience through an employer which is a type of deferred compensation plan that also incorporates a trust, and that trust means giving up a little bit of control that would otherwise go to the individual account holder. Ed, when we’re talking about those trust-based arrangements, what are some of the different– I mean obviously you end up with more complicated or a little more customized, like eligibility arrangements, right?

Ed: Yes, I want to get back to the non-trust individual account plans, the IRAs. The ultimate destination of the funds in these other arrangements is typically an IRA. At age 62, you can transfer money out of a pension plan to your own IRA even if you’re still working. Likewise, with a profit-sharing plan, fixed number of years, you can take your account balance out into your own IRA. The IRAs are the ultimate repository for the bulk of our wealth going forward. It’s not involving an employer. We’ll get into fiduciary rules. The eligibility requirements and like are very simple. The IRA is the optimum solution, either going in, but with a SEP IRA, you can’t have more than 100 employees. You use a government form, it’s one page. It’s so simple that my dog Jack could understand it, as contrasted with these other, typically employer-sponsored plans.

Chuck: Why would an employer do one of these others if the SEP IRA is so easy to do?

Ed: In the case of a SEP IRA, the amounts contributed are fully vested. In other words, you can take it with you immediately. As contrasted with the tax-qualified arrangements, there can be a vesting schedule. You can discriminate in favor of a highly compensated class of employees, that you can’t really do with a SEP IRA. My view is and frankly, our firm started with a profit-sharing plan, then we added a money purchase pension plan. Then we did cash balance plans and terminated those and we’re back to a SEP IRA. The point is this whole landscape changes as the complexion of the contributor changes. The one thing that’s very critical about all this area is that change is constant. You want to get to the very simplest form that you can get to, and it happens to be the SEP IRA. There is a trade-off, not more than 100 employees full vesting, eligibility requirements are very narrow, so it’s a cost. Nonetheless, turning to a profit-sharing plan and trust, no limitations on the number of employees. Different eligibility requirements. Contributions can be allocated, taking into account social security. They can discriminate. I don’t mean discriminate in the sense of against Polish people. I mean discriminate by taking into account someone’s social security benefit.

Chuck: That more highly compensated people, who are not going to get social security based on the upper range of their income, they can offset that by having larger contributions in the plan?

Ed: Yes, so when you look at the total package, someone making $200,000, the retirement benefit is the same percentage of 200 as it is of 50. The discrimination, it’s called a non-discrimination approach, but it’s really not discriminatory. It’s taking into account, benefits provided by employer contributions, which really are employee contributions by way of FICA and FUTA. Discrimination in the sense that you can have the contributions allocated among various employees, taking into account social security. In some instances, certain classes of employees. Now having said that, this is like a subdivision with a big gate around it. You can get into it, but it’s very complicated to handle. Why? There are fiduciary requirements on the part of how you deal with these funds. Remember, they’re someone else’s funds. If you’re the trustee, all these issues about a fiduciary. Two, there’s annual filings that are required. Three, you can’t have debt in the plan without attracting a special tax. Next, you can’t engage in a prohibited transaction, a related party can’t do certain things. You can’t necessarily borrow from the fund. You can, to limited extent. Bottom line is, while it’s flexible, we’ve got limitations on contributions and what is defined as compensate. If you have $10 million in W-2, you can’t put away 1%. Only the $300,000 or $250,000 of comp is to be measured in determining the percentage of contributions. In other words, yes, it’s a great benefit but there are all kinds of fences around what you can do. Very complicated.

Chuck: These plans Ed are, the trustee is really holding, and the trustee is typically the employer, is holding the funds for all of the plan participants even though– so has all these fiduciary duties that you’re talking about with respect to all of the plan participants, might even include terminated employees that they’re fiduciary to.

Ed: They would want to be terminated. I would want my money. I would want investment advice paid for by the company.

Chuck: Right. The interesting thing is that in a lot of these plans, the employees really have the impression that they have their own account, right?

Ed: Well, unless you have an individual accounting permit, individual direction of the investments, but then who’s reviewing those? Now typically the best does not have any direction and you manage, that you the trustee could be an individual, or by the way then, we have these investment advisers coming into the picture, then you have to address the question of friction costs, whose skin is in the game here. It sets up a whole new series of rules that is a compilation of everything we’ve talked about to date.

Chuck: That’s an interesting point you just made and a matter of public policy, not necessarily public policy in terms of what politicians are debating these days, but maybe what academics debate sometimes these days is the distinction between giving employees the choice to participate in selecting their own individual investments versus the fact that– and this is really a fact, that most people, when given that choice will end up choosing in ways that really is not in their own best interest. In the ideal world, you would have the trustees picking the investments for everybody in the plan. Of course, no trustee wants to do that, because if they’re in charge of the investments for everyone, then they’re that much more likely to be sued if the investments don’t go well. It seems to me, what we’ve seen is this industry heading to a place where they just give employees this enormous menu of investment options and good luck picking them, right?

Ed: It’s so wrong. It’s the worst possible thing an employer can do. Typically, the employer should possess a level of financial sophistication, not possessed by the various employees. There are exceptions, but I will tell you all the teachings we’ve talked about in the antecedent webcast here about investing, Rule of 72, all those go into this. Hopefully, the employer will have a level of sophistication, that they will give credit to themselves, and will hire an investment adviser and perhaps consider Vanguard with low friction cost funds. That’s the best for all concerned.

Chuck: I’m going to recall a conversation you and I had 20 years ago. That’s probably slipped your mind by now.

Ed: I was five years old then.

Chuck: Yes, or I was, one of us was. You were talking about your firm’s retirement plan and the fact that you had reviewed, because at that point in time it wasn’t a SEP, but it was a single trust plan but where each employee had the ability to select their own investments out of this menu. You were bemoaning the fact that the attorneys, who were more highly compensated members of the firm, had made these investments in the stock market and all of the staff had picked a CD, a bank instrument as their investment option, so they weren’t even keeping up with inflation. You were sort of, “What am I supposed to do about this that I, as an employer I really– these people are sacrificing their future and yet I’m almost on the sidelines here?”

Ed: Yes. It’s a real issue, what is your relationship with the folks that you work with and are you a fiduciary? I’m not suggesting that the employer is, but this isn’t a welfare state. These folks depend upon you for a W-2 and for some sort of arrangement. Social security may work, it may not work, who knows where that’s going? This is a much broader issue. I’m not talking about capitalism versus a welfare state. I’m talking about what is the role of the employer. It comes down to, let’s go ahead and invest in a wide range of low friction costs funds that emulate the return of the stock market or the gross domestic product, over a long period of time.

Chuck: Now, in current law, and this is a relatively new development, that the Department of Labor has allowed for, what are now referred to as these qualified default investment alternatives, so that a plan can– This has very little to do with what all is on the menu, but what you can do as an employer is, instead of defaulting an employee who doesn’t make any kind of investment election in the plan, now an employer, instead of just having that money sit in cash until the employee decides on an investment, you can default them into a better option than that. The most common arrangements either involve a mutual fund that’s a so-called balanced mutual fund. It might be a 60% stock, 40% bond mutual fund, or what’s become extremely common in the industry is that the default goes into a so-called target date fund, where again, that’s a fund that’s based on the employee’s age. The fund manager will select some sort of mix between equities and fixed income. I think the conversation that I had with you 20 years ago is less likely to happen for employers today, because now they can just default their employees into something where at least a part of the– where everything’s been invested in securities, with some arrangement between stocks and bonds. The money is just not going to sit there, just simply in cash, waiting for the employee to make a decision, in the modern era.

Ed: Yes, that’s a positive development. I think there are several very, very good books on this topic and around the recommended reading list and it should be addressed. The bottom line is, you can lay off the investment function, but you go through the whole drill about selecting investment advisers, low cost, low friction costs, platforms that hold, all those issues that you must contend with as an employer. As an individual investor, you try to put as much away as you possibly can, hopefully in a low friction costs equity portfolio, and take it out as soon as you can, profit-sharing after a fixed number of years. You can transfer your vested account balance to your IRA, where you have individual control. More specifically, an investment flexibility and distribution flexibility. We’ll get to that later. Let’s assume that you have 3 children and your aged 65. Your IRA happens to be $900,000. Well, how do you handle that $900,000, your overall estate plan? The easier approach is you divide that IRA into three IRAs. I mean child one is the beneficiary of a third of one, child two, and child three. When you’re a ghost, they get those IRAs and they can do with them what they please. In the meantime, you take the same amounts out for each of the IRAs per year. A magnificent approach that’s not available to you in the tax qualified/trustee arrangement. The press, the movement is to get your money into an IRA, individual direction and flexibility in terms of investments and distributions. Does that make any sense to you?

Chuck: Well, it does, and this is one of those areas where the employers’ interests and the employee, or at least the retired employees interest are pretty solidly aligned here, because the employer doesn’t really want to be incurring the expenses and the administrative hassle of managing assets for an employee who’s already retired. At the same time, for all the reasons you just stated and many more, the employee really doesn’t want that money still sitting in an employer plan, but would really prefer to have the flexibility of moving it out into an IRA where they can do things like divide it into separate IRAs or pick their own custodian or whatever. Really, the only advantage for the employee is if they happen to have an arrangement where the employer continues to pay fees for the custody and the management of those assets, even post retirement. What I found is that fewer and fewer employers actually do that. Usually, especially after you separate from service, you’re paying your own fees for whatever’s sitting in that plan anyway, so you might as well just get it out and get it in an IRA, which is what the employer wants you to do.

Ed: It’s in your best interest.

Chuck: Yes, typically what they will do, a plan will have a provision in there that says, if you are separated from service, you really have only two options when it comes to taking money out of the plan. You either take the entire balance as a lump sum, or you take an annuity over your lifetime, and they don’t want to give you any further flexibility than that. The reason is because they really want to encourage you to just take that lump sum and roll it into an IRA.

Ed: There’ll be two publications posted on the website. One about the various tax-qualified arrangements. We’re just now talking about the IRAs and the defined contribution plans, but the other is the government publication on IRAs, how they’re going to be handled. This area, in passing, is the most complicated area of the internal revenue code. There is nothing simple about it, because there’s not only the tax issues, coverage, vesting, discrimination, contributions, but it’s the distribution questions outright or in an IRA. Without a doubt, the government has put all sorts of fences around this great opportunity, and accumulate as much as you can, as early as you can, and get it out into an IRA, and get away from the tax-qualified plan if you can do that. What about the 401(k) plan, Chuck?

Chuck: Yes, that would be an example of this type of plan. The 401(k) plan is one where typically what you have is some type of what they refer to as an employer match, coupled with an employee deferral of income. Here, what will quite often be the case, is that the employee will decide to participate in the plan by picking a set percentage of W-2 wages that will go into the plan, and only the first $280,000 in compensation for each employee can be considered. In other words, if your salary is $1 million, for the purposes of the plan, you say I’m going to set aside say 6% of my compensation, you can only take 6% of that first $280,000, just anything you earn above that is disregarded. There’s a cap in terms of the amount of salary that’s considered in making the deferrals. There’s also a cap in terms of the total amount that you’re allowed to defer, and these caps are adjusted each year according to inflation. Currently, $19,000 can be deferred in an individual year, and of course, if the person is over the age of 50, that cap is actually increased by an additional $6,000, so that’s the so-called catch up contribution that the employee is permitted to make, but then these plans will typically involve the employer having some type of a match in order to encourage employees to participate. What you’ll often see is an arrangement where they’ll say, “Look, for the first, say, 10% of your income that you elect to defer into the plan, I, as the employer will match that, half a percent for each percent.”, so that what happens effectively is that if you’re an employee, let’s say you decide you’re going to set aside, I’ll just stick with this 6% number, you’ll get 6% of your own salary that goes in and then the employer will add, in this example, an additional 3%. By making that election to put 6% into the plan, you save the payroll tax that you would otherwise have to pay on that salary, you save the income tax that you would otherwise have to pay on that salary, and the employer is giving you an immediate 50% return on your investment. All that money grows in an account, to speak, that’s allocated for your benefit within the plan. Now, the employer part of that contribution will still be subject to whatever vesting schedule the employer has built into their plan design. In other words, if you’re just hired and in the second year of employment, you participate in this plan, the employer puts in some money for you, and then you separate from service the very next year, you may be taking none or just part of that employer contribution with you when you leave. Whatever the employee defers is fully vested from the moment of deferral. It’s one of these things where it is a no-brainer for employees to participate in these plans, because even though it’s not purely an employer making these contributions, typically there’s some kind of an enticement that the employer puts in to the plan design in order to get employees to participate. I would say that it’s very silly to not defer, at least the amount that is necessary in order to get the maximum employer match in the participation in the plan. Really, I would say, defer as much as you possibly can. If you can afford to defer that full $19,000 per year, then that’s what you should be deferring in this plan, because that money is going to be fully vested, and it’s going to grow tax-free until you ultimately take it out.

Ed: Remember, you’re saving 20%. You’re never going to pay the 20% tax who would otherwise be payable with W-2 earnings.

Chuck: Right. It’s really a no-brainer to participate in these. Of course, the big catch-22 is that typically, your most important time in life to participate in a plan like this is when you’re young, when it has the longest period of time available to grow, and yet, that’s also when people are least likely to participate, because that tends to be the point in their career where their salary is as low as it’s ever going to be. I don’t know how to express in words the importance of telling people who are in that position, that they will never regret the decision to go ahead and crimp, and grit their teeth, and do whatever they need to do to participate in these plans while they’re at that age. That growth will pay for itself many times over, and by the time, a decade down the road, 15 or 20 years down the road, they’ll look back and be very, very grateful that they did.

Ed: Look at the numbers again, and we talked about this before. Let’s assume you’re deferring $10,000 per year over 40 years. At 6%, that’s a $1.5 million. Let’s assume you’re not deferring 10, but you’re deferring for the 401(k) plan and your highly cap is at $40,000 a year, which is what we’re talking about. At $40,000 a year, or 4 times $1.5 million, that’s right around $6 million. Now, let’s assume for a moment that you can do 10%. Instead of $10,000, at $4.4 million, you do $40,000, so it’s 4 times $4.4 million. That’s $16 million-plus. I’m not suggesting you should try to have $16 million in your IRA, but the numbers demonstrate why the deferral of self-gratification is so, so critical, flexibility, creditor protection, and it’s the greatest thing since, near sliced bread. We’ll get to these; I’ll point it’s the greatest thing since sliced bread. Deferring self-gratification is key, discipline, friction costs. It is a fantastic opportunity that I think is only available in this country.

Chuck: Well, Ed, going back to that scenario, let’s say that you figure out a way, when you’re young, to defer $19,000, the full amount that you’re allowed to defer, and you get an employer match that, let’s say it’s not a full match, so you’re not–

Ed: You’ll get 6% just presume.

Chuck: Right. Still, let’s say that between what you defer and what the employer differs, you’re putting $25,000 away in these 401(k) plans and you’re doing it at a very young age. You gave the example before of someone who could accumulate $16 million in this plan, but let’s say that you have much more modest goals than that, well you could see a person like that end up in a situation where by the time they’re age 50 or 55, they don’t $16 million accumulated in this plan, but what they have is a couple million or $3 million and that gives them a freedom. Even though they’re still quite young and very far away from retirement age, it gives them the kind of financial freedom to be able to make decisions at that stage in their life that are– that might be the stage in life where someone’s worried about putting a kid through college and then, “Well, okay, I’ve got this nest egg set aside for my retirement that’s going to continue to grow, and I now am able to focus on putting kids through college,” or something like that. None of this works if you’re not participating when you’re young.

Ed: Chuck, a listener might their ask, “Okay, wise guys, what’s in it for you? Why are you guys doing this?”

Chuck: Yes, we just like to watch the growth happen, right? I think that what I’ve seen is kind of randomness with respect to who’s really benefited from being able to make these kinds of decisions at those critical times in their lives and who has not. I just think that it’s everybody should have access to that knowledge and advice and be able to participate. There’s no reason why this should be something that is only available to people who just happened to have parents that happened to have coached them in the right direction, or whatever the case may be, because these are simple things that are available to most people.

Ed: Well, when people have asked me that question, “Why are you doing this Ed?” I’ve said, well, I really am a fiduciary in my day job, and my entire career has focused on transparency. What is really going on here? What’s the bottom line? It’s kind of an educational process. When I get back to the continuum, we’re kind of teachers here and we have no ax to grind, other than as we’ve expressed, so we have no skin in the game. We’re not looking to attract more law business. We’re not looking. I’m not sure what else we’d be looking for. I feel good about this, this podcast, this series. I sleep well and I have to watch out for being run over by a lot of people, but I’m not looking to be part of a back-scratching opportunity that doesn’t result in unadulterated, uncompromised arise. If you don’t like it, I’m sorry. A client of mine, a lawyer client of mine I talked with just the other day said, “Ed you know, you are an obnoxious SOB, but the results aren’t too bad.” I’ll take that as a takeaway and next time, we’ll be talking about the greatest opportunity not only the ESOP, but then after that, the defined benefit plan and the cash balance plan.

Chuck: I’m looking forward to it.

Ed: Okay. Thanks, folks.

Thank you for listening to Money Talk. Please join us again and do check out our previous Money Talk topics.

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