by Tony Novak, CPA, MBA, MT revised 11/16/2011
Small business owners and professionals often seek to maximize their tax-deductible retirement plan contribution during their peak earning years. For baby-boomers, this is often an attempt to play catch-up for the years they have gone without saving.
The defined benefit plan can be a powerful tool for this type of retirement planning because it allows tax-deductible contributions up to 100% of earned income. But the cost to set up and run a traditional defined benefit plan often runs several thousand dollars per year even for the smallest businesses. The cost of these plans has caused them to decline in popularity over the past ten years. This article examines another type of defined benefit plan which costs practically nothing to set up and administer and is therefore a strong tool for retirement planning for small businesses and professional practices.
An annuity plan is defined in Tres. Reg. 1.404(a)-3 as "a pension plan under which retirement benefits are provided under an annuity without a trust." In practical terms, the annuity plan differs from a qualified plan only in that the annuity plan does not require the usual amount of paperwork. No trust document; no actuary's report; and no third party administrator's report is required. The premise is that an annuity plan is already well documented and well managed since the insurance company handles all the money, makes all the actuarial assumptions, and issues all of the paperwork as part of its function of managing the annuity contracts.
There are a few additional requirements:
1. The plan must be funded exclusively with annuities. Annuity plans can be funded with individual contracts or group annuity contracts. (This article will focus on using individual contracts only).
2. The annuities must be issued by a properly licensed insurance company.
3. The policy must state on its face that the policy is non-transferable.
4. The annuity must require level annual (or more frequent) payments and the annuity contracts only.
5. The benefits listed by the plan must match the benefits provided by the annuity policy. A written plan can refer to or incorporate the annuity document in defining benefits and conditions. All of the benefits offered by the employer's plan must be guaranteed by the insurer.
6. There may be no security interest in the annuity contract and policy loans are not allowed.
Although there is no requirement from the IRS that the annuity plan be in writing, good business sense would dictate that the business us a Plan Document and, in most cases, a Summary Plan Description. A simple document in the form of a corporate resolution would suffice for a one person business. Many firms use a full prototype defined benefit trust agreement in conjunction with an annuity plan just for clarification of all the plan details.
Any business, regardless of its form, is eligible for an annuity plan. A self-employed person is an eligible "employee" for the purposes of participating in an annuity plan (IRC 403(a)). The criteria for excluding part-time, union or young employees is the same as listed in IRC 401 for other types of qualified retirement plans.
Annuity plans are treated basically the same as a qualified plan for tax purposes. Reg 1.404(a)-3 allows the deduction of premiums paid by the employer. As long as the contribution formula meets the non-discrimination requirements of other qualified retirement plans, then the deduction will be allowed.
Defined benefit plans can be attractive to businesses for a number of reasons. First of all, the owner is likely to get a greater benefit from the plan if he or she is older and receives a higher level of compensation. In some cases the owner can allocate 80% or more of the plan contribution to his/her own account.
The defined benefit type plan makes retirement planning simple. Since the plan design tells you how much income you can receive at retirement there is less guesswork by the employee as to whether he or she is "on target" with retirement savings. For example "40% of current pay starting at age 65" would be a very realistic formula for a small business.
Defined benefit plans tend to allocate a higher percentage of the older employees toward retirement savings. This formula makes more sense in terms of today's "economic reality" where many young people often just do not care about retirement savings. This leads many business owners to think that they are wasting their money be treating young employees the same as older employees in terms of retirement plans. The defined benefit formula addresses this concern.
When an annuity plan uses a defined benefit funding formula, the IRS exempts the plan from the need to make minimum required contribution as usually required for a defined benefit plan under IRC 412. Reg 1.412(i)-1 says that a plan is not subject to minimum funding requirements if funded entirely by annuities. For this reason, these plans are often called 412(i) Plans. There is no need to hire an actuary for the administration of these plans, so operating costs will be lower than for traditional defined benefit plans.
A target benefit annuity plan is perfect for a small business when the owner wants to shelter a large sum of money but doesn't want the cost of employee contributions or high administrative fees.
In recent years the proliferation of variable annuities has raised some interesting questions with regard to annuity plans. May an annuity plan be funded with variable annuities? Is the employer limited to using "fixed" accounts for funding purposes?
Can an employer base his plan contribution on the guaranteed rates of return in the contract when current rates are actually higher? Can a participant direct the investments of his own defined benefit plan? Unfortunately, there are no solid answers since the IRS hasn't gotten around to addressing these issues yet.
For design purposes, A planner should probably use the current interest rate offered on the "fixed" account option of the variable annuity contact and the guaranteed income option tables included inside the annuity contract when calculating the allowable plan contribution. An actuary is not required, and most planners with a financial calculator can do the calculation in a few minutes.
Cautious planners may wish to address these ambiguous issues by calling the plan a "target benefit annuity plan" rather than a "defined benefit annuity plan" and proceed as usual in the design and setup of the plan. A target benefit annuity plan is actually a defined contribution plan which allows contributions to be recalculated annually to account for investment performance. Of course, as a defined contribution plan, tax-deductible contributions are limited by IRC 415 to a maximum of 25% of earnings. It is possible that strong investment results would further reduce the allowable plan contributions in later years.
Also, keep in mind that while a defined contribution plan has the effect of setting lower maximum contribution limits for older employees, it also raises the maximum contribution for younger employees. As a practice tip, we have found that high income employees under age 45 will generally be allowed a higher maximum contribution under a defined contribution plan. Employees over age 45 will generally get a higher maximum deductible contribution allowance under a defined benefit plan.
There is some evidence that suggests that variable annuity plans achieve a slightly higher net rate of return than comparable mutual funds in self-directed investment accounts. This result is achieved despite the higher fees that annuities must charge.
Variable annuities are so new to the investment market that it will be a number of years before anyone can say for sure how variable annuities stack up throughout the full market cycle. But clearly the average variable annuity contract has outperformed the average fixed annuity contract in recent years. The "fixed account" and "family of funds" options offered by most variable annuities has encouraged even the most cautious investors to explore the world of equity investments. This is a good thing in itself since most people invest too conservatively in their own self directed retirement plans.
Secondly, the variable annuity offers customer service, administration and reporting systems that rival even the best run 401(k) plans. An employee of a small business can get the same level of customer service as a Fortune 500 company. Most services are accessed through an (800) telephone number. The choice of five or six investment choices is more than adequate for the majority of investors and avoids making retirement plan decisions unnecessarily complicated.
Third, we all know that it is just a matter of time until we see a market correction which will send investors back to seeking guaranteed principal and fixed rates again. The annuity offers the option to switch to a guaranteed account with just a single (800) telephone call. Traditionally these fixed annuity accounts surpass the rate of return on government bonds, money markets and bank CDs.
Fourth, the IRS grants more favorable treatment to early withdrawals from an annuity plan than from a qualified retirement plan. Prop Reg 1.403(a)-2 grants capital gain treatment for distributions on death or separation from service. Normally early distributions from a qualified plan is considered ordinary income. IRC 403(a)-1(b) refers the handling of annuity withdrawals to Sec. 72 for calculating tax on distributions.
Finally, the annuity relieves the investor of the risk of outliving his/her money in retirement. The news about life-prolonging medical technology and the proliferation of scams targeted toward the elderly indicate that this risk is real and must to be addressed by the financial adviser. From an insurance viewpoint, this concept is similar to life insurance but with the opposite outcome. For an annual charge of about 1.25% of invested assets, a purchaser of an annuity "locks in" a life expectancy and minimum interest rate under today's conditions and is protected from an adverse move in either factor. The insurance company cannot change its minimum guaranteed income amounts even if average life expectancy increases to age 120 by the time a young employee retires!
The annuity account is protected from mismanagement or bad investment decisions by family or guardians or in the twilight years. The account is protected from attachment by creditors, including bankruptcy of the owner, because it is part of a qualified retirement plan protected by ERISA. On the other hand, these accounts offer the investor the opportunity to get a higher level of income as current market conditions dictate during the working years. This is clearly a win-win situation for the investor.
Qualified annuity plans may be require periodic tax returns, including a Form 5500. This depends on the size of the plan and the number of participants. Small plans with a single participant may be exempt from filing requirements.
If you try to find a chapter on annuity plans in most retirement planning textbooks, you will likely find only a few short pages tucked in somewhere between the chapters on "qualified plans" and "non-qualified plans". Annuity plans have been largely ignored outside of the 403(b) non-profit area. The pension departments of most major insurers do not support defined benefit annuity plans. There is a good chance your accountant and pension attorney has never handled an annuity pension plan for a small business. If you set up an annuity plan, you are on your own as far as design and client support.
There are likely to be clarifications coming from IRS on the use of variable products in regard to annuity pensions plans. It seems clear that the IRS not foresee the dynamic growth in the use of variable and hybrid annuity products when the 412(i) regulations were developed. Clarifications could restrict the liberal use of these products in annuity pension plans or could open the door to growth in this type of retirement benefit.1
1The Pension Protection Act of 2006 created a new type of retirement plan known as a "DB(k) Plan" that will be available to small businesses beginning in 2010. This new design effectively allows this type of pension benefit plans to be funded with non-insured securities while still enjoying the simplified administration of defined contribution plans. The DB(k) enjoys all of the benefits of a target benefit annuity plan plus removes even more of the restrictions, so there appears to be no need to continue these annuity plans past 2010. Current funding vehicles (fixed and variable annuities) may remain, but now other investment choices will be added.
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