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Cash Balance Plan Vs Investing in Open Stock Market

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  • Cash Balance Plan Vs Investing in Open Stock Market

    I am a recent grad in my first real job as an attending. I am and plan to continue to max out my 401k and do backdoor roth iras for myself and my wife.

    My group has a cash balance plan that is managed very conservatively (to avoid the potential of having to put in more money if the plan took a big hit). Therefore, the max return on investment is set to 4% (with any surplus used to protect against future losses).

    I understand the huge tax benefits of a CBP in the front end. However, as a young physician just starting a career, does it make sense to take part in such a CBP? based on some quick calculations assuming a 7% annualized return in the open stock market, it seems that taking that initial hit with the taxes in the front end will still work out to better gains at about year 18-19, and definitely wins out over a 30 year time period.

    Is it worthwhile just because of the asset protection it offers? Is there something I am missing? I assume not all CBPs are run so conservatively...


  • #2
    Thanks for the thoughts. I have been trying hard to get as much detail as possible, but many answers have been a little hand wavy.

    Here are some additional points:
    1. Fund is managed very conservatively: "primarily bonds" is what I am told. Don't have % breakdown.
    2. I would definitely be responsible for fees, but could not get a very detailed breakdown of fees/costs exactly. There are fixed Alfred and fees that are a % of portfolio. I was quoted a 300-350 dollar for a smaller account having 20k in it. No further details where available from my contact.
    3. If the plan happens to make >4% over many years and there is a surplus/certain percentage of overfunding, actuary will issue special allocation to the participants.

    I agree. Cbp's like this one seem to be a great deal for those close to retirement, as in less than 10 years, but for everyone else may not be worth it. Investing in cbp is itemized in wci's 10 commandments. Thus I wanted to make sure I wasn't missing anything before I opted out.

    Any other thoughts or comments would be greatly appreciated.


    • #3
      The thought that comes to mind is that you likely won't stay with this group your whole career. Let's say you make a change after 3 - 5 years. You are 100% vested after 3 years. The downside of low returns for a relatively short period would, imo, be overcome by the tax-deferred rollout (vested amount, of course) that you would now have under your control to invest in a better portfolio.
      My passion is protecting clients and others from predatory and ignorant advisors 270-247-6087 for CPA clients (we are Flat Fee for both CPA & Fee-Only Financial Planning)
      Johanna Fox, CPA, CFP is affiliated with Wrenne Financial for financial planning clients


      • #4
        Earlier in my career I was deciding between CBP vs spouse 457b vs taxable account (after maxing 401k/PSP and backdoor Roths). We went with maxing CBP first then non-gov 457b then taxable. A few things I learned:

        1) As a doc, it is very unlikely your effective tax rate in early retirement will be even close to as high as your marginal tax rate while working (which is the relevant comparison you want to make). The more $ you can afford to defer tax free the better, even into a crappy plan. This will make the cash balance plan a winner for almost all docs.

        2). Most cash balance plans are invested conservatively. Ours is 60/40 stocks bonds which is not what I like, but you can always decrease bond allocation elsewhere to offset.

        3). Most plans pick a conservative benefit of 5% or 30 Yr Treasury or similar. Doesn't really matter much what they pick, as if the plan underperforms this you'll have to put in more (in tax deferred $) to catch the plan up. If it overperforms, you will put in less. Your actual return will end up being the return of the plan net of any fees.

        3). Make sure you are immediately vested and can roll over to an IRA or another 401k if you leave the group.

        4). Find out how often catch up payments are required. Be aware that as your balance grows, your catch up contributions can become very large, particularly if the market crashes. This is "good news" in that it is more tax free money going in while "buying low" but can be a burden to many participants that can't afford it.

        5). Fees matter. Find out if there is an advisory fee, and the average fund costs. Ours uses a non optimal mix of index and active funds with an ER of 0.35. Not horrible. In the end I would of used it even if fund ERs were worse.

        6). Mist think 7% return you quote for taxable account may be tough to reach anyway now even if you are 100% equities with current P/E and extended bull market. 4-5% really not that bad.

        7) Make sure your group is making docs that retire or leave the group true up before leaving it you could end up with a shortfall when you cash out. This is legally required but not always done.


        • #5
          My major reason for using the CBP is tax minimization. Every $ I don't defer now, I lose 45% in state and federal taxes. It is very realistic to plan on rolling over your CBP to an IRA upon retirement and then slowly converting to Roth with an effective tax rate much lower, perhaps 20% or even less. Will depend on other factors such as age upon retirement, presence of a built up taxable account, ability to delay SS, and other forced income such as 457b drawdown, BUT......

          It should definitely save you big time on taxes if your a high earner now. Still a no brainer IMO.


          • #6
            Thanks for the thoughts TheGipper. Assumptions have to be made, but I am still not seeing the numbers come up better for CBP even with the tax deferment benefit.

            Assuming a 40% tax rate now and 20% at retirement, and a 4% annual return on the CBP (which seems way more than reasonable based on historic bond averages and the conservative nature of the fund) vs a 6% annual return in the regular stock market with post-tax dollars (no 30 year period in a past has made less than that), when all is said and done, that 2% difference in expected annual return over 30 years more than makes up for the initial tax hit. further, that isn't factoring in the higher fees associated with CBP.

            From my understanding, our CBP is primarily bonds (guessing 80%), so very different than your 60/40 stock/bond split, where I think you should expect a higher return. Definitely assumptions can turn out to be wrong, but is it unreasonable based on historical data that over 30 years I would expect more than a 2% better return on investment in the stock market rather than the bond market?

            I realize there is no 'right' answer, but makes me nervous when people say that it is a no brainer, and I a still struggling to understand why. the majority of my group agrees that it is a no brainer, and from reading WCI, that is my impression from WCI as well. But I am struggling to understand why based on expected returns in a conservatively managed CBP versus the market.

            But my take home from your comments Gipper is that I can use my CBP as my bond allocation (and put less than the max), and just have no additional bonds elsewhere in my portfolio. So I wouldnt be comparing bonds in CBP versus stocks outside, but comparing bond investment in a CBP versus outside of a CBP, in which case CBP wins every time.

            Thanks! Any other thoughts would be helpful.


            • #7

              Three points that might persuade you:

              1)  Do you plan to stay with this group forever?  Odds would say no.  When you leave and roll over your CBP into an IRA or another 401k, you have cemented your tax deferral benefit without the long term fees or 80/20 AA.  This is the same argument for contributing to a stinky 401k.

              2)  With some planning, I bet you could withdraw or Roth convert these funds for less than 20% effective tax rate in early retirement.

              3)  You can always convince your group to change the AA of the CBP.  Most plan documents allow for discretion or range of AA.  May be tough, but you may be able to convince your partners to up the equity exposure or change the plan altogether.

              Many would disagree, but I do count my 60/40 CBP in that ratio towards my overall AA.  Some keep it off the books as a extra pension, some count it 100% bond/fixed.  In the end the target (4% for you) is irrelevant.  You will earn its performance minus net of fees.

              You can always wade in with the minimum amount until you have a better grasp of your plan.  Most plans will let you change your contribution about every three years or so.


              • #8

                Point 1 is definitely correct.


                Point 2 depends on a lot of factors.  As i mentioned you need to look at what your total “income” (including spouse) will be.  In fact this is actually a good reason to develop your after tax accounts to allow this to happen.  Otherwise you get into a situation with tons of money in qualified plans and unless you want to spend early retirement “poor” (which i dont recommend), it isnt guaranteed you can convert at such a lower rate.


                If the partners are older they are unlikely to up the equity percent.  What i think you could get changed and should get changed is “the rule” that the plan distributes the extra every year.  What you want to do is actually over contribute for a year or two so that in some years you have NO REQUIRED contributions.  The reasons for this is that a DB plan affects how much you can put into your 401k if you are contributing to the DB plan that year.  Years when you DONT contribute to the DB plan, you can max the 401k to 53 or whatever it is at that time.  With the DB plan you get what the benefit is and have to contribute accordingly.  With the DC type plans, you get whatever it grows to.  In a DC plan, contributing more will result in a larger account in the end (assuming same investments).


                I wouldnt just put the minimum in.  The reason is these plans are expensive and its like a load.  It can be 1.5k per year just to have the plan not accounting for any fees for the investing.  So if you put in 50k per year then thats like a 3% load.  If you only put in 10k then thats like a 15% load just to have the plan.


                I have a DB plan as ive mentioned before and its okay but it isnt necessarily going to save me money.  It might but i actually hope it doesnt.
                Click to expand...

                I think obviously the big point is that every plan is unique and someone can have a good plan, while another can have a very poor plan, so its hard to have a simple yes or no.

                How come you cant just contribute the max to your 401k anyway? I dont currently have a cbp/db, but when I looked into them they all were in combo with your 401k with the goal to max out both with DC first of course.

                There are several ways to get the money out or convert at a lower rate that dont require retiring early and poor, but definitely requires planning to do right. I have compromised on the taxable account side by having a large allocation to muni bond funds. Even with low/minimal capital appreciation the tax free nature is very powerful, when compared to after tax inflation adjusted returns of say an index.


                • #9
                  Zaphod is correct. Most of these plans are in addition to and should not hinder your ability to max out your standard defined contribution 401k/PSP/403b.

                  Also correct many ways to plan and get funds out eventually at a minimum effective tax rate. If you haven't built enough of a taxable account, but instead have been paying off your mortgage, you could always downgrade your primary home and live off the proceeds which are tax exempt up to 500K gain + any improvements. Google and look into Roth conversion ladder strategies.


                  • #10
                    If you have to cover DB shortfall ,are you required to reduce your DC limit for the years when you cover plan shortfall?


                    • #11
                      It is my understanding that the computations that determine the max contributions allowed for your DB plan will vary based on many factors (including average age of participants).  Have heard of caps ranging from 20K to 125K.  I think the IRS limit is in the low 200K range.  From my limited experience, docs who used these plans were all still allowed to max out their 401k/PSP.  I don't think their is an combined limit between the two, but could be wrong if someone is putting in over 150k/yr into the DB plan.  Maybe one of the board experts can correct me if I'm off base.


                      • #12
                        Thanks for all the comments. Definitely a more complex topic than I was anticipating.

                        My understanding is like Gipper's, where the DB and 401K maximums are independent of one another. There are people in my group maxing out their 401k and putting in over 200k in the DB.

                        Some responses to other comments:

                        I am in a large multispecialty group, and doubt I will have much input/sway into how the CBP is managed/allocated.

                        I do anticipate staying in the group for a very long time, I hope. If not, then I agree, short term CBP would be a good way to go.

                        I have the option to enroll in the CBP every 3 years, when it opens up to new participants (or old ones can drop out). We are at that 3 year cycle now.



                        • #13
                          mzakary:  for me, its just ************************ hard to pass up the upfront 45% tax savings.

                          alexDDS:  I don't think so.  By law, you must catch it up.  What many fail to consider is that these catch up contributions are no big deal in the early years, but lets say that your account has grown to 500,000, the market goes down 30%, and your plan does not have a cushion surplus.  You could be on the hook for a 30% + defined target (5%) catch up, that would be something like $175k. almost 15k extra per month.  Granted that's pre-tax, so it will only feel like another maybe 8-9K/month, but still a wallop if you haven't budgeted for it.  Great to "buy low" with tax free dollars if you can afford it.  If you can't it may force you to temporarily suspend you 401k contributions.

                          I'm curious to what others who had CBPs in the 2008/2009 window did with the big shortfalls.  ?Dissolve plan.  ?Catch up


                          • #14

                            I’ll look up the limit when I get a chance but no you can’t contribute the max to a DC plan and to a DB plan in the same year. I think WCI has touched on this before. In his case if memory serves me correctly he maxs out his DC plan which limits his DB plan contribution. I do the opposite but then in other years have no DB requirements and put in the full 53k.
                            Click to expand...

                            This cant be correct, none of the options I've seen have had this issue. It would depend on your plan, but if self employed and not part of a group thats setting it up you would obviously do this for max benefit.


                            • #15
                              WCICON24 EarlyBird
                              You have to catch up whenever your plan says you have to and over the time course your plan calls for. Some require catch up payments q3yrs, some q1yr, some at random intervals.  Some split extra contributions over 12 months, some longer.  IMO, more frequent catch up is better, and lets you budget for it the following year.  For example, I know I am behind my 5% target by $12,000, so I can plan for an extra $1000 pre-tax monthly catch up the following year. But to each their own.  You should have control to change this to your liking.