Business Services Industry
New comparability - a new concept in profit sharing plan design
Los Angeles Business Journal, March 11, 1996 by Jeffrey D. Poland
Over the years, many thousands of organizations have maintained profit sharing plans, which are the least complex type of retirement plan. Under a profit sharing plan, an employer's contribution can be allocated to the eligible participants in one of several ways. In the simplest case, an employer contributes a specified percentage of the pay - e.g., 4% or 5% - of each employee. Under an "integrated" approach, an employer contributes a higher percentage of pay above the Social Security Wage Base ($62,700 in 1996) than of pay at or below the Wage Base. Another variation allows an employer, to a limited extent, to weight the contribution percentage by participants' length of employment, i.e., a "points" method of allocation. Regardless of the method, the internal Revenue Code limits the annual contribution per participant to the lesser of $30,000 or 25% of pay.Employers like the flexibility of profit sharing plans because of the discretion they have to vary the amount contributed for any year. This is in contrast to defined benefit pension plans, which require contributions of actuarially determined amounts. An employer's contribution to a profit sharing plan can range for any year from zero to the maximum tax-deductible amount of 15% of the total pay of the participating employees. Moreover, despite the "profit sharing" designation, contributions do not have to be tied to profits in any way. Also, unlike most defined benefit pension plans, profit sharing plans are not under the jurisdiction of the Pension Benefit Guaranty Corporation and do not have to pay premiums to that agency.
From the perspective of many employers, a significant disadvantage of profit sharing plans has been the inability to weight contributions in favor of key employees to any significant extent. Legislation effective in 1994 exacerbated this situation by capping at $150,000 the amount of an individual's pay on which contributions can be based. Here is where an "age-weighted" basis for allocating the contribution (i.e., a "New Comparability" plan) can be the answer, under the right circumstances.
The circumstances are right when the key people are older, on average, than the balance of the employer's work force. In other words, a New Comparability plan works something like a defined benefit pension plan, but without its disadvantages, by availing itself of the "cross-testing" provisions of the IRS nondiscrimination regulations. In summary, for nondiscrimination testing purposes an employee's annual profit sharing contribution, accumulated with interest to age 65, is converted to a pension payable at age 65 - by using an annuity factor to "convert" that contribution plus accumulated interest to an equivalent dollar amount of annuity, or pension, payable commencing at age 65. Each "equivalent" pension is expressed as a percentage of the participant's pay. Then, the percentages for higher-paid participants are compared to the percentages for other participants. If the difference between the percentages for the two groups is within prescribed nondiscriminatory bounds, all is well.
This cross-testing approach benefits older employees simply because of the power of compound interest. For example, a $900 contribution made for a 30-year-old employee will accumulate to $15,600 by the time the individual reaches age 65, assuming an 8.5% annual compound interest rate (which is in the range of interest rates permitted by IRS). To reach an accumulation of $15,600 at age 65, the contribution for a 55-year-old employee would have to be $6,900 at an 8.5% interest rate. Using one of the annuity factors prescribed by IRS regulations, $15,600 at age 65 would purchase an annual pension of $2,000.
Let's assume that the 55-year-old earns $150,000 and the 30-year-old earns $30,000. Then, an annual pension of $2,000 represents 6.7% of the 30-year-old's pay, but only 1.3% of the 55-year- old's pay. These are the percentages one looks at in applying the cross-testing provisions. To make it simple, let's assume that we increase the contribution for the 55-year-old so that the equivalent annuity at age 65 is exactly 6.7% of pay. This translates into a contribution of $34,500, which has to be reduced so as not to exceed the annual limit of $30,000. Thus, by the power of compound interest, a contribution of $30,000 for the 55-year-old (20% of pay) is equivalent to a $900 contribution for the 30-year old (3% of his pay) and satisfies the IRS regulations.
Use of the New Comparability basis results in two significant accomplishments for the employer: (1) contributions for the key persons are increased to the maximum amount of $30,000 (when contributions are integrated with Social Security the employer's total tax-deductible contribution of $98,700 (i.e., 15% of the total pay of $658,000) is not sufficient for the allocation process to produce $30,000 for each of the key persons); and (2) contributions for rank-and-file employees are decreased.
JEFFREY D. POLAND IS A CONSULTING ACTUARY WITH HIRSCHFELD, STERN, MOYER & ROSS, INC. ROCKEFELLER CENTER, NEW YORK, NY 10020