Defined Benefit Plan Update: Under New Regs, Will the Return on a Professional's Contributions Be Too Low?

We have recently published a white paper that discusses this topic. A copy of the white paper is available by calling Hugh Forcier at 800.328.4393, extension 7417. An executive summary is also available at the end of this article.

A general overview

In the last few years many professional service firms have adopted tax-qualified defined benefit (DB) plans that cover their partners/shareholders. By adding a DB plan to an existing tax qualified defined contribution (DC) plan, the partners/shareholders can greatly increase the pre tax contributions that they make to tax qualified plans.

Tax-qualified DB plans make sense for a high-income professional only if the professional can reasonably expect that his/her pre-tax contributions to the DB plan will produce more spendable retirement income—compared to the spendable retirement income that can be expected to be produced by making equal-effort, after tax contributions to some other type of account, such as a standard taxable account.

Until recently, virtually all high-income professionals would readily accept that more spendable retirement income would be produced by making pre-tax contributions to a tax-qualified DB plan. This was because each year's contribution to the DB plan could be immediately transferred to the firm's DC plan—or to an IRA. Under the DC plan or IRA, the professional would have broad investment control. With broad investment control virtually all high-income professionals would be convinced that more spendable retirement income would be produced. In this situation, it was easy for a professional service firm to reach a consensus on adopting a DB plan. Cash flow was the only likely obstacle.

On May 22, 2007, new regulations were published that permit in-service transfers to DC plans or to IRAs only after age 62. Prior to age 62, the contributions the partners/shareholders would make to a DB plan would be invested in a pooled fund.

Considering only compliance issues, a professional service firm would structure the pooled fund to produce a bond return. The majority of partners/shareholders at the typical professional service firm will be quite satisfied with a bond return on the contributions that they can make to the DB plan.

But it is likely that a significant minority of the partners/shareholders will be dissatisfied with a bond return. For the minority of partners/shareholders, the return will be too low: They may expect that less spendable retirement income will be produced. The partners/shareholders who will be dissatisfied with a bond return are those who (for whatever reason) would want to use a high-equity allocation for the contributions that they could make to the DB plan.

Because (subject to only cash flow concerns) the majority will want the professional service firm to adopt the DB plan (or continue an existing plan), the leadership of the firm will have every incentive to deal with the concerns of the minority on a basis that will satisfy the minority.

There are strategies that can be considered that can accommodate the concerns of the minority. However, the leadership decisions regarding whether (and how) to use these strategies will require it to evaluate some emerging compliance issues. Among those issues, some that we are finding to be very important are:

• The 401(a)(26) mandatory disaggregation rule issue—now pending before the IRS National Office


• The details of the "market rate" regulations for interest credits under a cash balance plan—if a cash balance plan structure will be used. (Cash balance plans have been the most popular choice of professional service firms)


• The Treasury's positions on variable annuity plan issues that are important to how professional service firms want to use variable annuity plans

The evaluation of these emerging compliance issues will be impacted by the professional firm's particular situation and by its risk tolerance on issues involving tax-qualified plans that cover its partners/shareholders. We have found that these professional service firm clients for which we serve as special benefits counsel (other large law firms, medical specialty groups, investment banking firms, and regional accounting firms) have a wide range of risk tolerance.

Our recent experience. For one reason or another, at this time almost all professional service firms need to determine whether and how they will (re)structure the provisions of their DB plans that control the return on partner/shareholder contributions. All of our large professional service firm clients are doing so. To date, two have made final decisions. Both happen to be large law firms.

While only two of our professional service firm clients have made final decisions, those decisions will be of interest to readers of the white paper. This is because these decisions reflect different assessments of some of the emerging, unresolved compliance issues:

• In early January of this year, one of the law firms had decided to adopt a DB plan at the end of this year that would be retroactive to January 1, 2007. At that time, it expected to be able to offer investment control to all partners. After May 22, 2007, it decided it will still adopt the DB plan—even though under the new regulations it will not be able to offer investment control prior to age 62. And:
  • It decided that it will structure its DB plan to produce a bond fund return to age 62—even though some of its partners who are now under age 62 would have preferred a balanced fund return. It will use a bond return structure because of its concerns about how some of the emerging compliance issues could adversely impact the use of a balanced fund structure.

• The other law firm has maintained a DB plan for a number of years. That plan has provided investment control for all partners since the plan's inception. After May 22, 2007, it decided it will continue the plan—even though it can no longer offer investment control prior to age 62 for future contributions. And:
  • It decided that it will structure its DB plan to produce a balanced fund return to age 62 on future contributions—because some of its partners now under age 62 strongly preferred a balanced fund return. This law firm was less risk averse than the other law firm on the issues that impact the choice between a bond fund structure and a balanced fund structure.

The leadership of each firm made its decisions regarding the bond fund return/balanced fund return after considering the identical descriptions of the compliance issues that we provided. The different decisions on the return question shows there is no "one-size-fits-all" resolution of these issues. The evaluation of these compliance issues involves matters of judgment.

The "must have" for the leadership of a large professional firm is a complete understanding of the emerging unresolved compliance issues before making its decisions. The white paper was written to further that "must have."