Pension Trends   Volume IX, No. 3, August 2008    

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The Really, Really Big Shew, 2008
          

The Really, Really Big Shew, 2008

Each week at the start of his TV variety show, Ed Sullivan would announce: "Tonight we have a big show, a really really big show" (he pronounced it "shew’"). Since he is credited with introducing TV audiences to Elvis Presley and The Beatles, his boast was appropriate at least part of the time.

If you have clients looking to tax defer the maximum possible contribution they can to a retirement plan, 2008 is likely to prove to be a really, really BIG show. In our August 2006 newsletter we suggested that the Pension Protection Act of 2006 (PPA) contained good news for small business owners who sponsor defined benefit pension plans. One of the changes brought about by PPA was to allow and encourage better and earlier funding of defined benefit plans. Not only were minimum required contributions increased, maximum deductible contributions were also increased - in effect, allowing employers to pre-fund a percentage of their pension liabilities.

What we and the rest of the actuarial community did not appreciate until we started actually crunching numbers is just how much more can now be contributed to a defined benefit plan. It is really, really big. Where the pre-PPA maximum annual contribution was $200,000, under PPA the maximum could, depending upon the fact pattern, be $700,000. The key is having prior service and crediting benefit accruals over that prior service.

PPA allows maximum contributions up to 150% of the liability for accrued benefits. The reasoning is that accrued benefits are promises that a plan is obligated to provide. By allowing plan sponsors to pre-fund a portion of its accrued benefit liability, plans are more likely to remain solvent in periods of down stock markets. This, in turn, takes pressure off the Pension Benefit Guaranty Corporation (PBGC) which insures accrued benefits. While pre-funding rules were aimed at the larger plans whose failures in the early part of this decade put incredible pressure on PBGC reserves, the same rules apply to small employer plans.

Thus it is possible for the owner of a small business to set up a defined benefit plan in 2008 that credits benefit accruals for service prior to 2008, and thereby create a really, really big pension deduction by pre-funding a portion of the associated liability.

There are many good reasons why a plan sponsor may want to pre-fund its plan, high taxable income this year with less certainty of high income in the future being reason #1. However, there are three attributes of pre-funding to keep in mind. First, pre-funding does not mean higher funding. Tax deductible dollars put into the plan in the early years via pre-funding will necessarily result in smaller contributions in later years. Pre-funding impacts the timing of deductions, not the totality of deductions.

Second, pre-funding can result in assets in a plan in excess of the plan’s liabilities. (Remember the amount of pre-funding can be 150% of the plan’s liabilities.) If a plan terminates with excess assets that cannot be distributed to participants, the excess is reverted back to the plan sponsor subject to a 50% reversion tax. There are mechanisms for using up excess assets, one of which is the passage of time that creates additional accruals, but plan sponsors need to be proactive in managing a pre-funded plan.

Lastly, providing employees with benefit accrual credit for prior service can be expensive. It is great to get an accelerated tax deduction, but the tax deduction needs to make business sense. The key question is how much of the accredited tax deduction will benefit the owner vs. how much is an employee expense.

In the right situation, pre-funding is an incredible new opportunity for the small business owner looking for the maximum possible tax deduction. For those of us with many years in the pension business, the hardest part is adjusting our thinking to really, really big numbers.

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This newsletter has been published in order to share general information with our professional contacts. The information presented in this newsletter should not be acted upon without first seeking the advice of a CPA, attorney or other benefit professional. 

Pension Trends, Volume IX, No. 3, August 2008
Copyright © 2008 Independent Actuaries, Inc.