Cash Balance vs 401K

[litovskyassetmanagement]

Kon - great post as always on the CB plans.

Are you seeing any concern or shift in fund selections within these plans given the low interest rate environment?

Yes, many firms are going into higher risk/junk bonds, dividend paying stocks, etc, to get the extra yield but in the process they subject the principal to excessive risk. In traditional DB plans where you would expect to pay out retired participants, investment goals are completely different, but somehow many firms treat CB plans in exactly the same way as DB plans, thereby causing plan sponsors quite a headache trying to deal with under- and over-funding issues. The problem is that many of those making investment decisions are firmly in the 'modern portfolio' mindset, so very few are interested in buying bonds when interest rates are zero. Totally understandable, however, when risk matters more than return, interest rates are irrelevant (as long as your portfolio is not too risky such that rapid increase in interest rates would make it go down a lot). We just have to look at the big picture. Bonds are there not for return (though in the past 2 years their return is good, but mostly because interest rates fell), but for relative safety and risk mitigation. Nobody really knows how long crashes can last (they can be as short as a single day or last decades), so given the relatively short horizon for most CB plans, they should be very conservatively invested. This is 'liability matching' approach is more consistent with what the goals are for CB plans vs. trying to 'nail' the crediting rate by matching it with an 'expected' return (which is a probabilistic return) without considering actual standard deviation of returns. Even if you run your CB plan in perpetuity, it is still essentially a year by year plan where investments should be relatively short maturity and low volatility.

[WCInovice]

Actually, freezing does exactly this - it allows you to contribute a lower amount. Also once in several years you can change the targets for partners who want to do so, and in addition, your contribution range grows with time, so if your plan was designed correctly using individualized rangers (vs. just fixed amounts, which is what I see done by lazy TPAs/actuaries), then you don't have an issue about contributing more or less vs. the target each year.

One thing to keep in mind is that if you terminate an overfunded CB plan, you have to pay 100% excise tax on any gains beyond the crediting rate. Also, you might not be able to terminate an underfunded plan unless you make contributions into it. Managing CB plan portfolio has to be done carefully and deliberately as when everything is great, nobody cares, but when things go south all of a sudden partners start realizing that this is not just another tax-deferred account, but an account with very specific rules that have to be followed, especially if you want to terminate this plan quickly. Thus low volatility is the best way to manage CB plan investments while taking all risk on the personal/401k plan side.

These types of plans can run in perpetuity if there is financial/business reasons for doing so. You are better off vs. investing after-tax, that's for sure, so as long as there is a critical mass of docs, you can run this plan for as long as the practice is around. The goal should be to run it in perpetuity, but with the understanding that you should have the option of terminating this plan for whatever reason - whether because the practice is merging/dissolving/getting bought out, or the market conditions changed, so as long as your investments are selected appropriately, you can and should be able to terminate the plan (including possibly once in a lifetime of the plan strategic termination where you close and re-open).

Kon - great post as always on the CB plans.

Are you seeing any concern or shift in fund selections within these plans given the low interest rate environment?

[litovskyassetmanagement]

Thanks all for the input.
We should all agree that the catecholamine response from a pizza coupon should always be superior to that of market fluctuations.

Appreciate the PPP intel. We have since been funded to our satisfaction, and did indeed use those factors.

We have been advised in the past that we were unable to simply contribute more or less annually to the Cash Balance Plan based on cashflow and performance. We started with a defined amount per partner, based on age. We changed the parameters once this past year, to increase the contributions across the board, and were advised to leave it be going forward. I will have to look into the concept of "suspending" the plan, as this is a new twist for us.

Currently, the practice contributes approximatelly $310K between the partners to the Cash Balance Plan. This comes at a cost of $36K, for employee contributions, actuary testing and TPA fees. Call it a 12% opportunity cost to save 40-42% if we were to take the same as income. This cost is in addition to the costs associated with the 401K. It is not insignificant, particularly in a year we are borrowing money to make payroll. I don't know the correct answer as to the relative role of bonds and equities, but it was made clear to us there is a risk associated with an overly successful CB portfolio.

We had agreed at inception that this plan was never designed to continue in perpetuity, but also never defined an endpoint. We thought we'd try it at least 3 years (TPA advice to pass the sniff test), and then see how much we liked it. Put another way, we have already owned and committed to the fact that there will be cancellation fees, and that the funds would be transferred to individual 401K accounts. The question then becomes, when is the right time to cancel a plan? Is it as arbitrary as a random point in time, retirement of some of the partners, or alternative opportunities? If a number of us are going to see a diminished income this year, is the opportunity cost worth what may only be a 29-37% savings, compared to a 0.4% tax drag in a taxable account? (5% State tax).

Curious if those with CB/DB plans have anticipated continuing the program forever, and if not, what is the rationale for ending it.
Thanks

Actually, freezing does exactly this - it allows you to contribute a lower amount. Also once in several years you can change the targets for partners who want to do so, and in addition, your contribution range grows with time, so if your plan was designed correctly using individualized rangers (vs. just fixed amounts, which is what I see done by lazy TPAs/actuaries), then you don't have an issue about contributing more or less vs. the target each year.

One thing to keep in mind is that if you terminate an overfunded CB plan, you have to pay 100% excise tax on any gains beyond the crediting rate. Also, you might not be able to terminate an underfunded plan unless you make contributions into it. Managing CB plan portfolio has to be done carefully and deliberately as when everything is great, nobody cares, but when things go south all of a sudden partners start realizing that this is not just another tax-deferred account, but an account with very specific rules that have to be followed, especially if you want to terminate this plan quickly. Thus low volatility is the best way to manage CB plan investments while taking all risk on the personal/401k plan side.

These types of plans can run in perpetuity if there is financial/business reasons for doing so. You are better off vs. investing after-tax, that's for sure, so as long as there is a critical mass of docs, you can run this plan for as long as the practice is around. The goal should be to run it in perpetuity, but with the understanding that you should have the option of terminating this plan for whatever reason - whether because the practice is merging/dissolving/getting bought out, or the market conditions changed, so as long as your investments are selected appropriately, you can and should be able to terminate the plan (including possibly once in a lifetime of the plan strategic termination where you close and re-open).

[litovskyassetmanagement]

2 avid WCI readers are having a spirited debate about the utilization of a Cash Balance plan during a bear market and impending recovery. We are a 5 member surgical group, 18 employees, and have maximized our tax deferred vehicles. Surgeon ages 42-52. We are also in the 5th year of a cash balance plan, set at a return of approximately 5%. Like many of you, we have come to a standstill with the COVID-19 pandemic, and are functioning at approximately 10-20% in the office with no elective surgeries, stimulus benefits hopefully pending.

Perspective #1: Continue funding the CB plan. It has functioned very well to diminish our taxable income, at the cost of admin/testing fees and a dampened return. It has allowed excellent accumulation of funds over a relatively short period of time, and did not diminish nearly as much as our 401Ks this past month. Stay the course, don't react to current market conditions and eventually cancel the plan and transfer the funds to our 401Ks. It is very predictable.

Perspective #2: Take advantage of the impending recovery, while sticking to investment strategy. Cancel the plan, pay the breakage fees (and catch up costs due to diminished returns), and transfer immediately to 401K. Each individual can then invest according to their own investment strategy. Cut some costs as this is going to be a skinny year for all of us. Consider restarting the plan in a few years, accepting a repeat of the front end cost. Invest in a taxable account if you have a better year than expected.

Basically I think we are debating a tax savings strategy vs an investment opportunity strategy, with both sides arguing that they can stick to their overall plan. Incidentally, a pandemic did not find its way into either persons written investment plan.

Would very much like to hear the thoughts of the WCI world.

There is no reason to close the plan as that creates its own issues. You don't want to close and re-open quickly, this will definitely raise IRS eyebrows. If there is a business reason to close a CB plan, then reopening one quickly thereafter is the last thing you want to do. Thus, it is not a strategy that will work unless you want to do a 'strategic' restart, in which case you have to talk with your actuary about how to best accomplish that, usually you want to run the plan for a number of years before that becomes a viable option.

All of our plans have received a 'freeze' recommendation from the actuaries, and this is a good course of action. Basically you can contribute a lower amount, but if you change your mind, you can undo the freeze by the end of the year, and contribute what you planned, so this is a win-win. I believe you still have some time until June to make this decision, so I wouldn't rush it.

As long as the plan still works for most of the docs, freezing is the best option at first, you can always terminate later (if you don't ever plan to restart it again, for example). This is also 'safe' money that should not be subject to much risk, as terminations under low market conditions can potentially be a big problem if the plan is underfunded.

[boarderdoc]

Thanks all for the input.
We should all agree that the catecholamine response from a pizza coupon should always be superior to that of market fluctuations.

Appreciate the PPP intel. We have since been funded to our satisfaction, and did indeed use those factors.

We have been advised in the past that we were unable to simply contribute more or less annually to the Cash Balance Plan based on cashflow and performance. We started with a defined amount per partner, based on age. We changed the parameters once this past year, to increase the contributions across the board, and were advised to leave it be going forward. I will have to look into the concept of "suspending" the plan, as this is a new twist for us.

Currently, the practice contributes approximatelly $310K between the partners to the Cash Balance Plan. This comes at a cost of $36K, for employee contributions, actuary testing and TPA fees. Call it a 12% opportunity cost to save 40-42% if we were to take the same as income. This cost is in addition to the costs associated with the 401K. It is not insignificant, particularly in a year we are borrowing money to make payroll. I don't know the correct answer as to the relative role of bonds and equities, but it was made clear to us there is a risk associated with an overly successful CB portfolio.

We had agreed at inception that this plan was never designed to continue in perpetuity, but also never defined an endpoint. We thought we'd try it at least 3 years (TPA advice to pass the sniff test), and then see how much we liked it. Put another way, we have already owned and committed to the fact that there will be cancellation fees, and that the funds would be transferred to individual 401K accounts. The question then becomes, when is the right time to cancel a plan? Is it as arbitrary as a random point in time, retirement of some of the partners, or alternative opportunities? If a number of us are going to see a diminished income this year, is the opportunity cost worth what may only be a 29-37% savings, compared to a 0.4% tax drag in a taxable account? (5% State tax).

Curious if those with CB/DB plans have anticipated continuing the program forever, and if not, what is the rationale for ending it.
Thanks

[WCInovice]

We have a very similar situation (small specialty physician group with age rage of docs of late 30's to 50's).

We are continuing our DB plan. We have filled the paperwork out to "suspend" it so we can make sure revenue for 2020 enough to fund it, but likely it'll be OK and we'll fund it in December.

I'm not an expert here, but I *think* you do have the option of "suspending" the plan and/or each year significantly ramping down your contributions if you'd like to then funnel that money into a taxable account. You could also stop the plan for 1 year, transfer that money to a 401k, then start it back up. But that comes with fees and though I *think* legal may be questionable.

Our conundrum is should we put a small amount of equities in the DB plan or not. Our goal in the plan is only 3%, but I'm not even sure bonds are going to hit that. We have traditionally done only high grade corp bonds or vanguard short term bond index type of investments within the DB cash balance plan....but do we need to re visit that strategy?

Would love some input here.

[Hank]

Make sure you are including the DB contributions and 401(k) employer match and profit sharing in your calculation above $100K of salary for the surgeons (and office manager and other employees who might be paid $100K+) when you fill out your PPP loan / grant application.

I don't think I'd kill the DB plan entirely this year. You may have to minimize contributions or suspend the plan if necessary. Your employee census may dictate how to deploy limited funds if volume and revenue remain low.

[Cubicle]

I have no experience with a cash balance plan. But I will say perspective #2 sounds like market timing. I do know the market will recover. But when is the question. And the possibility of a further significant drop is greater than zero.

I think I'd lean towards #1.

[boarderdoc]

2 avid WCI readers are having a spirited debate about the utilization of a Cash Balance plan during a bear market and impending recovery. We are a 5 member surgical group, 18 employees, and have maximized our tax deferred vehicles. Surgeon ages 42-52. We are also in the 5th year of a cash balance plan, set at a return of approximately 5%. Like many of you, we have come to a standstill with the COVID-19 pandemic, and are functioning at approximately 10-20% in the office with no elective surgeries, stimulus benefits hopefully pending.

Perspective #1: Continue funding the CB plan. It has functioned very well to diminish our taxable income, at the cost of admin/testing fees and a dampened return. It has allowed excellent accumulation of funds over a relatively short period of time, and did not diminish nearly as much as our 401Ks this past month. Stay the course, don't react to current market conditions and eventually cancel the plan and transfer the funds to our 401Ks. It is very predictable.

Perspective #2: Take advantage of the impending recovery, while sticking to investment strategy. Cancel the plan, pay the breakage fees (and catch up costs due to diminished returns), and transfer immediately to 401K. Each individual can then invest according to their own investment strategy. Cut some costs as this is going to be a skinny year for all of us. Consider restarting the plan in a few years, accepting a repeat of the front end cost. Invest in a taxable account if you have a better year than expected.

Basically I think we are debating a tax savings strategy vs an investment opportunity strategy, with both sides arguing that they can stick to their overall plan. Incidentally, a pandemic did not find its way into either persons written investment plan.

Would very much like to hear the thoughts of the WCI world.