t a time when businesses nationwide are jettisoning defined benefit pension plans in droves because of the prohibitively high cost, a niche of the DB market is thriving: 412(e)(3) plans. Funded with whole life and fixed annuities, the plans are fuelling a healthy demand for DB plans of fewer than 100 participants.
So reports the Boston-based market research firm Cerulli Associates in its second quarter, 2011 edition of the Cerulli Edge. Targeted to highly compensated businesses owners who are either sole principals of their companies or one of a few employees, the plans have become popular among executives who need to catch up on retirement savings.
According to Cerulli, 412(e)(3) plans (formerly 412(i) plans) now account for $51 billion in plan assets. And they are among one of several niche markets that Cerulli views as significant “asset-gathering” opportunities for advisors in the years ahead.
That 412(e) plans are included in the group may come as a surprise to insurance and financial service professionals who in past years backed off the plans because of heightened government scrutiny. Among the “abuses” the IRS has targeted since issuing 412(i)-specific revenue rulings in 2004 are plans that offer life insurance on the principals and none on the rank-and-file or different policy types for the two groups.
Some business have also invited the IRS’ wrath by giving plans participants too much coverage (amounts exceeding the prescribed limits under Revenue Ruling 74-307 or Revenue Ruling 2004-20) or involve policies designed to transfer cash value outside the plan and, thereby, avoid taxes.
But the plans hold much promise for those who are prepared to play by the rules and meet the target profile: owners age 45 and older who enjoy a steady cash flow and revenue stream; are seeking to maximize income tax deductions; and provide a substantial retirement benefit for themselves and (typically) 5 or fewer employees.
A fully insured qualified pension plan, the 412(i) is exempt from the complex IRC Section 412 funding rules that apply to all other defined benefit plans. Upshot: The plans are cheaper and easier to administer than conventional pension plans. (They don’t require, for example, hiring of a high-priced actuary to determine employee contribution amounts and benefits, as the plans are guaranteed by the insurer).
Also, by allowing contributions often three times greater than that for traditional DB plans (and up to six times more than in a defined contribution plan), the plans let an employer “fast-fund” retirement savings.
The higher contributions are matched by higher tax deductions for the employer/plan sponsor. That’s possible because the contract guarantees in the funding vehicles (generally 1.5% to 3% for whole life contracts and fixed annuities) are lower than the interest rate (generally 5% to 8%) used to calculate contributions to traditional DB plans. Thus, the lower rate of return requires a larger tax-deductible contribution to achieve the same benefit at retirement. To boot, the employer can deduct administration fees and take a take 50% tax credit on start-up costs.
Contributions for employees’ benefits grow tax-deferred, and the amounts are determined by a formula that factors in the employee’s age and income. At retirement, the monies accumulated can be rolled to one’s IRA account without taxation (until withdrawn from the IRA), taken in cash (as a taxable event) or taken as a monthly income for life (taxed as ordinary income as received).
To be sure, the 412(e)(3) plans is not for the faint-of-heart. Small business owners who adopt them have to make the same hefty contributions for at least five years. The rule applies both to them and, because the plans are non-discriminatory under ERISA law, those of all other individuals they employ. For that reason, sources say, the plan is generally not appropriate for companies that are in volatile industries or prone to widely varying revenue streams.
Also to consider: The plans must be funded exclusively with fixed annuities or a combination of FAs and whole life insurance, the latter being limited to 49% of the plans. The IRS mandated this requirement in 2004 to reign in a widely-marketed practice: distributing cash values to policy holders at low tax cost using artificially inflated surrender charges. The cash value would later “spring” to its real market value.
Additionally, life insurance dividends and excess interest must be used to reduce the following year’s contribution. And policy loans are not permitted under the contracts.
But on balance, 412(e)(3) plans clearly are advantageous for the right business client. They’re easy to understand, entail no investment risk and, as pension plans, are completely creditor-proof.
If you’re an advisor to business owners, this is one plan you should definitely have in your portfolio