Conquering the Challenges of Crafting a Firm Pension Plan

By Bruce Ashton

The typical law firm presents some interesting challenges—and opportunities—from a pension planning perspective. The firm has three significant “constituencies”: the shareholders or partners of the firm; the associate attorneys, who are typically relatively highly paid and often receive a significant share of their income in the form of a bonus; and the nonprofessional staff employees, some of whom, such as the office administrator, may be relatively highly paid, but the majority of which are not. Often, the goal of the firm is to provide as large a retirement benefit as possible for the partners, a fair benefit to the staff employees at a reasonable cost, and little or no retirement benefits to the associates, on the assumption that they desire to maximize current compensation through salary and bonuses. This goal is the assumption underlying the concepts in this article.

The current “plan of choice” in U.S. businesses, including law firms, is the 401 (k) plan. These plans are funded by employee deferrals up to a maximum permissible amount (currently $10,000). These deferrals may be matched by the employer, and the employer may also make an additional non-elective or profit-sharing contribution. Generally, if the firm makes a profit-sharing contribution for the partners, to maximize their annual contribution (currently $30,000), the same percentage of pay must be contributed for the nonpartners of the firm.

In this article, we'll show you how to take the basic 401(k) plan and through creative design features, use the basic 401(k) to meet the assumed retirement plan goal of providing maximum benefits to the partners, benefits for your staff at a reasonable cost, and benefits to your associates at essentially no cost to the firm.

BASIC CONCEPTS

Before getting into the design of the 401(k) plan, it is important to understand some basic concepts.

• Definitions. In a 401(k) plan, the amount deducted from an employee's salary for contribution to the plan is his "deferral." If the firm makes a contribution which is equal to a percentage of the deferrals, these are called "matching contributions" or "matches." If the firm makes additional contributions to the plan, not based on the amount of deferrals, these are "nonelective" or "profit-sharing contributions." Generally speaking, profit-sharing contributions are the same percentage of pay for all participants.

• Nondiscrimination Rules. Qualified retirement plans may not discriminate in favor of highly compensated employees (HCEs). HCEs are the employees, including the partners or shareholders of the firm, who make more than $80,000 in annual compensation or own more than 5 percent of the firm.

• Special 401(k) Rule. In a 401(k) plan, the average of the deferrals by the HCEs as a percentage of pay may not exceed the average of the deferral percentages of the non-HCEs (NHCEs) by more than 2 percent. This ratio must be tested each year using the "actual deferral percentage" (ADP) test. If the plan fails the ADP test, the firm must either put in a nonelective contribution (called a QNEC) for the NHCEs to bring up their average deferral percentage, or the plan must return elective deferrals to the HCEs, thus reducing the partners' retirement benefits.

• Maximum Considered Compensation. The total compensation which may be taken into account for purposes of the plan is $160,000. This means that even if a partner earns more than $160,000, the amount of his elective deferral to the plan will be divided by $160,000 to determine his actual deferral percentage. Based on the current $10,000 limit on elective deferrals, the maximum deferral percentage for HCEs is 6.25 percent.

• Top-Heavy Plans. If the partners have more than 60 percent of the benefits of the plan, the plan is "top-heavy." (This test looks at the accounts of the "key employees," the partners who own 5 percent or more of the firm, and those who make $150,000 a year or more and own at least 1 percent of the firm.) If the plan is top-heavy, the firm must make a contribution to the plan for all eligible employees, whether or not they are deferring a portion of their pay into the plan, generally 3 percent of pay for the nonkey employees.

• Coverage Rules. A plan may not limit eligibility disproportionately in favor of the HCEs. While there are several ways to test this, the simplest (and most common) is to compare the percentage of HCEs who are able to benefit under the plan with the percentage of NHCEs. If 100 percent of the HCEs are eligible, then at least 70 percent of the NHCEs must be eligible. If only 80 percent of the HCEs are eligible, then only 56 percent (70 percent of 80 percent) of the NHCEs must benefit.

DESIGN CONCEPTS

Now let's look at some design concepts which will help meet the firm's retirement goals.

• Eliminate the Associates. One of the first - and often easiest - steps in reducing the overall cost of the plan and satisfying the associates' desire for maximum current compensation, is to make the associates ineligible to participate in the plan. Since many of the associates may be HCEs (because they make more than $80,000), it is permissible to exclude them from the plan. And under the coverage rules, if there are HCEs who are ineligible, then the percentage of NHCEs who must participate may also be reduced (which means that even associates who are NHCEs may be excluded).

  Also, by eliminating the associates, if the plan is top-heavy, the 3 percent contribution need not be made for them. And if the firm makes profitsharing contributions, it need not do so for the associates. (Note that if the associates wish to make 401(k) deferrals, it may be possible to set up a separate, deferral-only plan for them.) Obviously, whether this works in a given situation depends on the demographics of the firm, but it is often a very easy means of redesigning the plan.

• Cross-testing. A second approach, which will permit the firm to put in maximum benefits for the partners at a reasonable cost for the staff, is to use "cross-testing." This is a form of permissible discrimination in favor of the HCEs. Without getting into detail, cross-testing looks at the benefit which will be available at normal retirement age, and the number of years until retirement, to determine the annual contribution. Through a process of averaging of contributions, the total amount which must be contributed for the partners is determined, and then the amount which must be contributed for the staff is determined. Generally, if the partners are older on average than the staff, in a cross-tested plan, it will be possible for the firm to contribute the maximum benefit for the partners at a cost of about 3 percent to 5 percent of pay for the staff.

  In a 401(k) plan which is cross-tested, assume that the partners will put in deferrals of $10,000 (the current maximum). The firm will contribute $20,000 for each partner (or at least each partner older than, say, 45) to bring them up to a total annual contribution of $30,000 (again, the current maximum). This represents a total contribution of 18.75 percent of pay. As noted, the cost to the firm will be in the range of 3 percent to 5 percent of pay for the staff (plus the deferrals which come out of the pay of the staff). Of course, this design only works if the plan passes the ADP test so that the partners are able to defer up to the maximum. That may not always be the case. And if the plan is top-heavy, there may be additional cost for the top-heavy contribution.

• Safe Harbor Plan. The newest development for assuring that the cross-tested design works as intended is to make the plan a "safe harbor" plan. The safe harbor rules of Internal Revenue Code section 401(k)(12) are designed to permit a plan to automatically pass the ADP test, thus assuring that the partners may defer the maximum $10,000.

  There are two approaches. The first is for the firm to commit to make a matching contribution on the deferrals of all IVHCEs equal to 100 percent of the first 3 percent of pay and 50 percent on the next 2 percent of pay. If the plan is top-heavy, the firm will still need to make the 3 percent top-heavy contribution. If the plan is cross-tested, the firm will still need to make the required profit-sharing contribution.

  The second approach is the one more likely to be useful to the law firm with a cross-tested 401(k) plan. Under the second method, the firm makes a 3 percent of pay contribution to all eligible h1HCEs, whether or not they defer to the plan and whether or not they otherwise meet the plan's service requirements (typically, 1,000 hours during the year). The contribution is 100 percent vested. However, for this 3 percent contribution, the firm receives the following benefits: the plan automatically passes the ADP test, so there are no refunds to the partners; the plan automatically meets the top-heavy contribution requirement, so there is no additional 3 percent contribution; and the plan will typically satisfy the requirements for cross-testing. In other words, the same 3 percent contribution may be taken into account for satisfying all three of these requirements. In a plan which is cross-tested and top-heavy, this may represent a savings to the firm of 3 percent to 4 percent of pay for the staff employees.

© 1999 NLP IP Company. This article is reprinted with permission from the October 1999 Law Firm Partnership & Benefits Report, Volume 5, Number 9.

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