Pension Overlay: The Art Of Making Up Lost Ground In A Hurry

Traditionally, an owner of a closely held business or professional practice has had to choose between implementing either a defined contribution plan (401(k) profit sharing plan) or a defined benefit plan. Each type of structure has inherent benefits and limitations. 401(k) profit sharing plans are generally viewed as being more flexible and less costly (from a standpoint of employee costs) however owners are limited to roughly $50,000 per year in terms of their own ability to participate on a pre-tax basis. Alternatively, defined benefit plans may enable the owner to make a substantially higher (often well in excess of $100,000 annually) pre-tax contribution for him or herself, but – until recently – with a tradeoff of diminished flexibility and high employee costs.

However, a significant planning advantage for owners came about through recent changes in pension law which opened the door to a planning opportunity known as Split Funded Defined Benefit Plans or Pension Overlay Plans. Under the right conditions these plans combine the employee cost control of a 401(k) profit sharing plan with the advantage of outsized pre-tax owner contributions. This new plan design has been a boon to owners who, due to market related poor investment performance or other factors, are now playing “catch-up”.

The use of a Pension Overlay Plan can often enable a high-income owner to accelerate 20 years worth of retirement savings into 7.

How Did This Change Come About?

The Pension Protection Act of 2006 clarified what it would take for such a plan to pass IRS scrutiny. The changes allow sponsoring employers to have both a 401(k) profit sharing plan and a defined benefit plan and, more importantly, for the plans to be fairness tested on a combined basis, as though they were one plan. The cross testing provisions essentially give the plan’s administrators the ability to convert any employer contributions made to the 401(k) profit sharing plan into benefits in order to compare them, for non-discrimination testing purposes, to the benefits provided under the defined benefit plan. The end result is greater owner control of the overall costs of offering retirement benefits since the defined benefit or Pension Overlay Plan may often be implemented primarily for the business owner(s) only. An added advantage is that the investment risk for the 401(k) profit sharing plan continues to be borne by the individual participants and not by the defined benefit plan or its trustee.

What Are the Significant Benefits of a Pension Overlay Plan?

  • The ability to make substantially larger tax deductible contributions for owner(s)

  • Better containment of the costs attributable to required contributions for employees

  • Flexibility in investment choices

  • Likely protection of plan assets from lawsuit and judgment under ERISA guidelines

  • Owner’s personal contributions to the plan are made on a pre-tax basis and are in addition to any current 401(k) and profit sharing plan contributions

Who is an Appropriate Candidate for a Pension Overlay Plan?

  • A highly compensated owner desiring additional retirement savings – especially those with a short time horizon until retirement

  • Owners and other highly compensated employees earning significant income who cannot save as much as they may desire in a pre-tax vehicle due to limitations under a traditional 401(k) profit sharing/match structure

  • High-income owners burdened by excessive personal taxation

How Does the Pension Overlay Plan Work?

  • A Pension Overlay Plan is a tax-qualified retirement plan established by a corporation, partnership, or sole proprietor. It is funded with a combination of the plan trustee’s choice of managed assets (stocks, bonds, mutual funds, etc.) and a whole life insurance contract specifically designed for pension funding. The plan funding limits are determined by retirement benefits earned by plan participants as they complete years of service.

  • The inclusion of life insurance allows for an artificially low interest rate assumption to be used in the actuarial calculation determining the contribution needed to provide a given benefit. This generates a significantly larger pre-tax plan contribution.

  • The final plan design may consist of a "stand alone" Pension Overlay Plan, but more commonly, a combination of 401(k) profit sharing and Pension Overlay Plan is used. Each Pension Overlay Plan is a custom design based on many factors and the exact contribution amounts for each participant are subject to actuarial testing.

  • Owners who already have 401(k) profit sharing plans in place may be able to implement a Pension Overlay Plan for themselves and maintain their existing 401(k) profit sharing plan for themselves and for the remainder of their employees.

  • Non-discrimination and minimum participation rules apply (IRC Section 401(a)(4) and 401(a)(26)

  • The plan passes non-discrimination testing in part because the 401(k) profit sharing and Defined Benefit plans are tested as a single plan (Treas. Reg. Sections 1.410(b)-7(d), 1.401(a)(4)-9(b)). That is, in determining whether the plan discriminates in favor of the highly compensated, the employer provided benefits under the profit sharing plan and the benefits provided under the defined benefit plan are considered as though they are provided under a single plan.

  • In addition, the combined plan is tested on a benefit basis, rather than a contribution basis (Treas. Reg. Sections 1.401(a)(4)-8(b), 1.401(a)(4)-9(b)(2)(ii)(B)). In other words, the contribution and interest credits under the defined benefit plan and the employer contributions under the profit sharing plan are turned into benefits payable at some future age such that the disparity in contribution rates is not being tested, but instead the ultimate benefits are being tested.

  • While life insurance is in place in the plan, the participant must report the current cost of life insurance protection (Table 2001 rates) as taxable income each year.

  • The plan should be considered as long term (at least 5-7 years) but can be reevaluated if there are significant business changes in the future and the plan poses financial hardship to the business.

How Are Initial Participation Limits/Elections Determined?

  • Owner/Partners will have the initial option to participate up to the contribution levels determined by the Pension Overlay Plan design.

  • Contribution levels to the Pension Overlay Plan generally should not be changed from year to year but changes may be considered as approved by the actuary. Additional flexibility can be gained by adjusting personal participation in 401(k) deferrals.

  • Future partners/shareholders would be considered in the overall plan design subject to review.

Is an IRS Determination Letter Issued?

  • The final plan design is submitted to the IRS for a determination letter.

How Are Non-Insured Plan Investment Assets Managed?

  • Investments in the non-insurance portion of the defined benefit plan account are pooled with no participant level investment direction by individual defined benefit plan participants. The owner(s), as trustee, has discretion over how the pooled account is invested.

  • Gains in investments may require a lower contribution in future years, whereas investment losses may permit a higher contribution.

  • Investments in the 401 (k)/profit sharing plan may continue to be self-directed and managed per individual risk tolerance.

What Administration is Required?

  • An actuarial firm handles the Plan administration, working in concert, if needed, with the owner’s existing 401(k) plan administrator.

  • Defined benefit plan participants receive annual statements from the actuary reflecting their portion of the plan benefit.

  • Annual statements include last year's account balance, the newly added deposit, interest at a plan-specified rate, and the current balance and are in addition to statements received for the 401(k)/profit sharing plan.

What Happens at the Death of a Participant?

  • Upon the death of an insured participant the life insurance policy death benefit is paid to the defined benefit plan. The plan must then pay this life insurance death benefit to the plan participant's named beneficiaries.

  • If the participant included the Table 2001 rate cost of insurance in his or her income, the plan beneficiaries will receive a portion of their survivor benefit free from federal income taxes.1

What Are the Options at Retirement?

  • As is typical with any defined benefit plan, one of the options is to offer the participant either a single-life or joint-life annuity payment. The plan may also offer a lump-sum distribution which the participant may elect to roll over to an IRA or other qualified plan.

  • There are several options to consider regarding the life insurance portion. If the employee no longer desires the death benefit coverage, the plan could surrender the policy for its cash surrender value and use the proceeds to help fund the retirement income benefit.

  • If the employee desires to continue the life insurance coverage, the policy would need to be removed from the plan by either a taxable distribution or a purchase for fair market value. Under no circumstances may the life insurance policy be rolled over into an IRA (although a rollover into a profit sharing plan is acceptable). If the employee wanted to transfer the retirement plan assets to an IRA, the life insurance policy would either need to be surrendered or removed prior to the rollover.

- Dan Darchuck, CEO