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Rethinking Retirement Plan Design for High Income Professionals

Plan design approaches of workplace retirement plans have evolved over time. The growth of defined contribution plans with cash or deferred arrangements, more colloquially known as 401(k) plans, has been remarkable since their introduction in 1981. In 1992, these plans accounted for 31.6% of employer-sponsored retirement plans; in 2007, they represented 79.5%.[1]

Under 401(k) plans, employees authorize employers to defer a portion of their pay for contribution to a retirement plan account. Subject to certain non-discrimination rules, employers may match employee contributions and make other non-elective contributions for the benefit of participants. The contributions could be invested in a variety of investment vehicles and grow tax-deferred.

401(k) plans were marketed to employers by an army of brokers, often representing well-known and established financial institutions or insurance companies. The brokers’ attitudes were clear – save the maximum amount permissible in a well-diversified and properly asset allocated portfolio. However well intended, our research suggests these overly simplistic recommendations may not achieve favorable outcomes for many high-income professionals.

We define a high-income professional as a firm principal earning more than 125% of the annual qualified plan considered compensation limit. The qualified plan considered compensation for 2011 is $245,000 and adjusted annually for cost of living.

General Professional Practice Characteristics

Professional practices share similar organizational characteristics. Principals and other professional staff developed expertise in a specialized discipline, which required extensive study and formal licensing. Skill improvement through continuing professional education helps professionals remain competent to serve the evolving requirements of clients and patients. Practices are compensated based on the professionals’ collective expertise and ability to remain billable, with non-professional staff serving in support functions. Typically, professionals spend years mastering their craft before practicing independently or acquiring an equity interest in an existing practice.

Once a principal, professionals spend time building their business and may not focus on retirement security until the practice is further established. When retirement does become a priority, our experience suggests most professionals desire a standard of living comparable to their pre-retirement working years. This sentiment is consistent with the retirement income adequacy standard established by the Presidents Commission on Pension Policy in 1982. The Commission suggested that individuals achieve an adequate retirement by replacing 100% of pre-retirement income – a 100% income replacement ratio.

High Income Professional Plan Design Problem

Consider a professional practice with the following characteristics: the principal is a high-income professional age 45, earning $392,000 after profit distributions. The practice also employs one non-principal professional earning $84,000 and three support staff earning $35,000 each.

The practice is doing well, so the principal adopts a 401(k) plan at the advice of her broker. The maximum qualified plan contribution for the high-income professional is $49,000 in 2011, or 12.5% of her gross income. Under typical safe harbor 401(k) plan designs, funding this level of benefit for the principal requires the practice to contribute approximately $22,000 for the other staff members.

Presuming our high-income professional wishes to retire at age 65, earns 8% pre-retirement net annualized investment returns, and maximizes her annual 401(k) contributions, our professional’s retirement account balance would grow to approximately $2.3 million – a seemingly respectable figure, approximately $1.2 million inflation-adjusted.[2] Presuming our high-income professional lives until age 85 and earns 4% post-retirement net annualized investment returns, her account balance would provide her with a $1.6 million retirement portfolio shortfall.

Under the aforementioned scenario, the principal’s 401(k) plan retirement account will replace only 42.4% of her pre-retirement income, or approximately $166,000 annually. Living a lifestyle beyond these means will cause the high-income professional to outlive her retirement savings. Even when considering a modest Social Security Benefit of $2,500 per month, the retirement portfolio shortfall is cut only to $1.4 million. Simply put, because of relatively restrictive contribution limitations, 401(k) plans may not enable high-income professionals to achieve adequate retirement income.

Enhanced Plan Design Solution

One solution to improve the plan design and increase the income replacement ratio for the high-income professional calls for the practice to sponsor both a 401(k) plan and a defined benefit pension plan. Under a defined benefit pension plan the practice commits to paying a specific benefit for life starting from a staff members’ retirement. Amounts funded to the defined benefit pension plan are tax-deductible, just as are employer contributions to a defined contribution plan. The maximum annual defined benefit, based on government limits, is $195,000 for 2011. The benefit amount is determined in advance and typically based on factors such as compensation and years of credited service.

The following is a common defined benefit accrual formula: 2% of final pay per year of credited service. Let us consider, from the earlier example, the nonprincipal professional earning $84,000 retires, having been credited with 20 years of service. Under the aforementioned formula, his benefit would be $33,600 annually or $2,800 per month for life. Over the life of the defined benefit plan, the practice would be required to fund the plan sufficiently to satisfy the promised benefits.

Since the benefit is definitely determined, the employer bears the risk of investment returns, which has caused defined benefit pension plans to fall out of favor with large employers. However, this risk can be mitigated by reducing the variability of investment returns through conservative investment vehicles such as government securities and high quality investment-grade corporate bonds.

By reducing investment return variability, employers gain greater certainty of forecasted funding requirements to satisfy the plan’s emerging liabilities. Actuarial calculations will determine the employer’s periodic funding obligation and an enrolled actuary must annually certify the plan’s tax reporting.

Improving Retirement Income Outcome

Revisiting the earlier example, let us presume the practice adopts a defined benefit plan design that maximized the principal’s benefit accrual to the $195,000 annual benefit limit. Let us further presume the practice adopts the same 401(k) plan design previously referenced, which supplements 42.4% of the principal’s pre-retirement income, or approximately $166,000 annually.

In total, the combined plans offer the high-income professional retirement income of approximately $361,000 annually, which replaces 92% of her pre-retirement income. After adding social security income of approximately $2,500 monthly, the high-income professional replaces nearly 100% of her pre-retirement income.

By leveraging both retirement plans, maximizing contributions to the 401(k) plan and maximizing the benefit accrual under a defined benefit plan, the high-income professional could retire comfortably at age 65 and enjoy a standard of living comparable to her pre-retirement working years. Although our plan design approach may be more complicated than a stand-alone safe harbor 401(k) plan, it accomplishes the desired outcome and precisely satisfies the client’s objectives.

[1] Craig Copeland, “Individual Account Retirement Plans: An Analysis of the 2007 Survey of Consumer Finances, With Market Adjustments to June 2009,” Employee Benefit Research Institute Issue Brief, no. 333, August 2009.

[2] Inflation assumption based on CPI-U Dec-Dec average since 1913, as reported by the Bureau of Labor Statistics.

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ERISA Workplace Retirement Plan Limits

The federal government annually publishes updated qualified retirement plan limits, which impact the contributions, benefit accruals, and compliance of ERISA covered qualified retirement plans. The below tables summarize the most significant changes in recent history.


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