Contribution Options for Small Cash Balance and Defined Benefit Plans

By David J. Kupstas, FSA, EA, MSEA

David J. Kupstas, FSA, EA, MSEA

David J. Kupstas, FSA, EA, MSEA Chief Actuary

At the end of the plan year, some of our small cash balance (CB) and traditional defined benefit (DB) clients will contact us wanting to know what “the” contribution is for the previous year, as though there was a single option for what they are required to put in. In fact, there is not one single right amount to contribute. The employer can usually choose to put in a little, a lot, or something in between.

Some of the options the employer may have are as follows:

Option 1: Minimum required contribution (CB and DB). Every year, an actuarial valuation must be performed for each CB and DB plan. Among other things, the valuation generates a minimum required contribution and a maximum deductible contribution. These contributions are determined in accordance with generally accepted actuarial principles and are based on employee data, the plan provisions, and a set of assumptions about the future. Under current law, there is usually a pretty wide range between the minimum required and maximum deductible contribution.

In many cases, the reason a small employer has adopted a CB or DB plan is to be able to make significant tax-deductible contributions. For that reason, the minimum required contribution is often of little interest to our clients, although understandably there may be a year every now and then in which a minimum contribution is desired. If the small employer regularly wants to contribute the minimum, then it means the benefit formula may have been set too high and should be amended downward.

It is more likely that a larger employer will gravitate toward the minimum required contribution. They tend to be less interested in the tax aspects of DB plans and view contributions as an expense similar to rent, health insurance, and copier paper. Many of the DBs sponsored by our larger clients have frozen benefits and are underfunded. Those employers either can’t afford to contribute more than the minimum, or they are biding their time until investment gains or higher interest rates lift them to full funding and the ability to terminate the plan.

As a general matter, with all the funding relief that has been passed by Congress in the last 15 years, a plan to which only the minimum contribution is made likely has a poor funding ratio, meaning assets are not adequate to pay all benefits. It’s kind of like making only the minimum payment on your credit card. Not quite, but close.

Option 2: Maximum deductible contribution (CB and DB). If making only the minimum contribution is not advisable, putting in the maximum would seem to be a good thing, right? It certainly is what many small businesses had in mind when they adopted a CB or DB plan: stuff as much money in the plan as possible and get a tax deduction. This is a winning strategy for the most part, although care must be taken to ensure that more isn’t put in than can be easily gotten out. For any plan participant, there is a maximum amount that may be withdrawn as a lump sum at any given age based on a number of factors. Heavy excise taxes could result if there is more money in the plan than may be paid to participants. Therefore, an employer probably should not contribute more than is needed to fund the combined maximum payouts for all participants, even if greater amounts are fully tax-deductible.

In some cases, a one- or two-person employer might be willing to fund a couple of years ahead. The plan might be overfunded if lump sums were paid out today, but there would be the opportunity for the plan’s benefits to “grow into” the assets in the trust over the next year or two or three. This strategy works fine as long as the owner continues working and is willing to cut back on future year contributions. Should the owner suddenly stop accruing benefit service, the plan could terminate in an overfunded state, leading to the aforementioned excise taxes.

Option 3: Contribution under an old funding method (mostly traditional DBs). There was a time many moons ago (before 2008) when enrolled actuaries selected all their own assumptions and worked with the employer in choosing one of the available funding methods – methods with names like individual aggregate, entry age normal, and projected unit credit. The Pension Protection Act took a lot of that discretion away from actuaries and required them to use assumptions and a funding method mandated by the government. Despite that, if the actuary and plan sponsor decide the plan’s needs are not being served by the new valuation rules, there is nothing that says you can’t run an old-style valuation and produce a “recommended” contribution different from the usual minimum and maximum amounts. The employer’s funding policy could then say that this recommended amount will be what’s contributed, so long as it is greater than the minimum and less than the maximum under PPA rules.

Option 4: Amount needed to bring assets in line with account balances (CB). Assume on the last day of the year that the asset value is $800,000, the sum of prior account balances is $850,000, and the hypothetical allocations for the year are $200,000. If $250,000 is added to the plan, then both assets and account balances will equal $1,050,000. This seems like a very pure funding strategy – always aim to have assets be equal to the account balances. Chances are, this contribution will fall within the min-max range. On the other hand, if there has recently been a sharp downturn or upswing in asset values, the employer may not want to make up for that loss or gain right away if it believes investments will quickly pop back up or come back down to earth, as the case may be.

Option 5: The hypothetical allocations for the year (CB). Using the above example, the employer could choose to contribute $200,000, which is the sum of the amounts allocated to all participants’ hypothetical accounts. This may be what our clients have in mind when they ask about “the” contribution for the year. If the plan is pretty close to 100% funded, give or take a few percentage points, this strategy may be reasonable. It is easy to understand. However, if the assets are significantly out of line with the account balances, either on the up side or the down side, then simply contributing the year’s hypothetical account balances might not be the best strategy, as it will keep the plan overfunded or underfunded.

Option 6: Amount needed to bring funded ratio to a certain level less than 100% (CB or DB). This is an expansion of Option 4 above. It probably isn’t something a small plan is going to pursue. Often, you’ll hear that government plans have a target of, say, 80% funding. For every dollar of pension obligations, the goal is for the plan to have 80 cents on hand. Whether 80% is a sufficient target is a debate left for another day, but many states are comfortable with such a goal since there are so many other ways to use tax dollars and it is expected the plan will be around for many years. (Perhaps they are kicking the can down the road to let a future administration deal with the shortfall?) As mentioned above, small employers typically are looking to maximize deductible contributions and usually do not shoot for specific funded ratios other than 100%. 

Option 7: Amount needed to bring PBGC variable-rate premium to $0 (CB or DB). Some of our clients’ plans are covered by the Pension Benefit Guaranty Corporation. Those clients that are covered view PBGC premiums as wasted money since they will probably never benefit from those premiums themselves. In addition to a flat per-head premium, the PBGC assesses a variable-rate premium equal to 5.2% of any underfunded amount. The PBGC has its own definition of what constitutes an “underfunded” plan. A plan may be quite well-funded by most definitions but underfunded in the PBGC’s eyes, particularly in low interest rate environments.

Suppose an employer has a contribution in mind that leaves it, say, $100,000 underfunded in the upcoming year under the PBGC’s definition. If that employer can scrounge up an extra $100,000 to put into the plan, it will save itself $5,200 in PBGC premiums. While this may be more than the employer intended to contribute, it might help to think of the extra amount simply as an advance payment on the upcoming year’s contribution.

Option 8: Amount needed to achieve some tax goal (CB or DB): After preparing its tax return, the employer’s accountant may say it would be nice if company income was $500,000 lower. If $500,000 is within the plan’s min-max range, voila! A $500,000 contribution may be made to the plan and deducted, thus getting the taxable income down to where the accountant would like to see it.

As you can see, small CB or DB plan sponsor has a number of options for what to contribute for a given plan year. There is not one “right” number. The plan sponsor will want to consult with its actuary, accountant, and other advisors to arrive at the best contribution amount for its situation.

— Topics: Retirement, defined benefit, cash balance