The best retirement plan solution may notalways be the one that results in the highestamount of deferred income. As a result, it'simportant to closely examine the drawbacks,as well as the benefits, that such a solution might present.
One Georgia-based medical clinic found this outfirsthand. In 1999, the firm's investment committee wasstrongly considering the addition of a defined-benefitplan to their retirement program, a move that wouldhave greatly increased the physician partners' taxdeferredsavings. But a closer look at the new planrevealed some distinct disadvantages that discouragedthe committee from going forward and prevented whatcould have been a costly mistake.
Roughly 50 practicing physicians owned the firm,which was organized as a limited liability company. Thepartners, along with about 800 employees, participatedin a $40-million 401(k)/profit sharing defined-contributionplan, and benefited from an employer matchingcontribution on a portion of salary deferrals as well as adiscretionary profit sharing contribution each year.
Between contributions from their own salaries, theemployer match, and the profit sharing plan, many of thepartners maximized the deferrals allowed by federal lawto their defined-contribution accounts ($35,000 at thetime; the 2004 limit is $41,000). When a local actuarialfirm approached the clinic about increasing the partners'deferral levels through a cash balance plan arrangement,the investment committee listened with interest.
A cash balance plan is a defined-benefit arrangementthat provides for specific annual employer contributionsand typically a guaranteed investment return. However,participants have individual investment accounts, similarto those in a defined-contribution arrangement. Manycompanies choose cash balance arrangements over traditionaldefined-benefit plans because the individualaccounts simplify the task of communicating plan bene-fits to employees and because cash balance plans tend tohave lower costs.
Risk and Costs
A review of the cash balance arrangement confirmedthat it indeed would meet the firm's goal to allow thepartners to make contributions to their own accountsbeyond the 401(k) plan's limits. However, some drawbackswere worth consideration, including:
• Employer contributions to the plan would be mandatory,not discretionary as in the defined-contributionplan, which could negatively affect the firm's cash flow.
• The firm's audited financial statements would be requiredto reflect separate, actuarially determined pensionexpense calculations, increasing reporting complexity.
• The firm would have to pay insurance premiumsto the Pension Benefit Guaranty Corporation for eachparticipant, increasing plan costs.
The biggest drawback, however, was that the plan'scash flow would not necessarily balance with accruedbenefits. Participant accounts in cash balance plans areactually hypothetical, "crediting" participants with benefitsbased on contributions under a plan's terms andearned interest. However, these credits would by nomeans reflect the actual funding of the plan, whichwould be determined actuarially, or the investment performanceof plan assets.
The firm would assume all investmentrisk and be forced to make up any shortfall should liabilitiesexceed assets—as the result of a market downturn,for example. In addition, partners who chose to leave theplan after a relatively short time could have accrued benefitsthat the plan had not fully funded. In essence, contributionsfor partners who stayed in the plan for a longperiod would subsidize the benefits of those who left.
In the end, the choice was clear for the investmentcommittee. The risks and costs of implementing the cashbalance plan outweighed the benefits of being able toshelter twice as much income from taxes. The committeeoverwhelmingly decided to stick with the existingdefined-contribution plan.
In hindsight, the decision turned out to be a prudentone. The severe downturn in equities over the past 3years could have created a worst-case scenario for thefirm—declining plan assets, rising benefits in participants'accounts, and substantial, additional employercontributions that could have severely hurt cash flow.
is a senior consultant in
Vanguard's Plan Consulting Group. The Plan
Consulting Group is a specialized unit of
Vanguard's Legal Department, devoted exclusively
to providing business-focused compliance and
consulting services for Vanguard's retirement savings
plan clients. Vanguard welcomes questions or
comments at 800-890-8502.
Donald C. Cardamone