412(i) Defined Benefit Plan

 The 412(i) Defined Benefit Plan is a very attractive option for certain business owners and professionals whose businesses have the following characteristics: 

• Owner or principal generally 50 years of age or older.
• Very small number of full time employees.
• High and consistent level of income.
• Preferably no previous plan in place.

Unlike more sophisticated plans available to these prospects, these plans are simple and inexpensive to administer and are easy to understand.  Because these plans are fully financed through traditional life insurance and annuity products, there is no market risk associated with these plans.  This type of insurance-based plan also affords the participant protection of assets from lawsuit or bankruptcy.  This is quite often an attractive feature for doctors.  In addition, this insurance-based plan avoids the complication associated with OBRA ’87.  These plans can often be fully funded in as little as six years. 

The most attractive feature of the 412(i) plan is derived from the funding rules in the tax code.  Because this is a defined benefit funded by life insurance with low but guaranteed rates, very large amounts can be put in the plan to meet the defined benefit income goal for retirement.  Many individuals can literally put more money in the plan than they earn.  While this is rarely done, it does demonstrate the enormous tax savings potential of 412(i).

The 412(i) Fully Insured Defined Benefit

Pension Plan for the Small Business 

A type of defined benefit plan exists that is a very viable plan design for the “right” small business situation.  What follows is a general description of this plan and a discussion to help identify the right type of situation where this plan will have appeal.  The plan is called the 412(i) defined benefit plan.  It is also referred to as an insurance contract plan.  It will be referred to here by its third common name, the fully insured defined benefit plan. 

This discussion will focus on the problems created by legislation for the traditional defined benefit plan and why the fully insured defined benefit alternative offers a solution to many of these problems.  The fully insured approach is not for everyone, but small businesses with very few employees should be aware of this alternative.  It can produce appealing results and solve some big problems in the right situation. 

Generally, the fully insured plan would have the most appeal in a business with five or fewer employees where the owner is age 50 or older.  The business should have a steady cash flow.  The best situation is one in which there has been no previous plan in existence.  Establishing a new fully insured plan can mean substantial deductions for the business and meaningful retirement benefits for the participants. 

Over-funding and Over-regulation of Traditional Defined Benefit Plans 

Many existing traditional defined benefit plans may have become over-funded due to tax law changes in the last few years.  In some situations, conversion to a fully insured plan may restore deductible contributions to the plan and eliminate penalties for reversion of excess assets upon plan termination. 

Fully insured defined benefit plans are not a recent innovation, so why should this approach warrant closer consideration today?  The reason is related to what might be termed “over-regulation” of the traditional defined benefit plan in the small business.  The Employee Retirement Income Security Act of 1974 began an era of massive regulation of retirement plans.  Originally, the goal was to end abuses in the funding of plans and to more adequately secure the rights and benefits of plan participants.  Through the years, much of the regulation has seemed to be directed more at raising revenues than curbing abuses.  At any rate, the end result of years of changing the rules for defined benefit plans, limiting benefits, cutting deductions, and attacking plan actuarial assumptions, has served to add confusion and complexity, and has increased administrative costs for the small business.  The knockout punch for defined benefit plans came with the passage of the Omnibus Budget Reconciliation Act of 1987 (OBRA ’87).  The changes for defined benefit plans mandated by this Act have caused many small businesses to re-think the viability of the defined benefit plan.  These changes will be discussed below, along with the reason why the fully insured plan counters most of the problem areas. 

Specifically, OBRA ’87 contained mandated for defined benefit plans which included: 

• Quarterly contribution requirements with penalties for the improper amount or timing of the contributions.
• Penalties on the reversion of excess assets to the employer at plan termination.
• A new full funding limit substantially reducing or completely eliminating deductions in some situations; and
• New mandates that each actuarial assumption be reasonable standing alone and no longer reasonable “in the aggregate”.

Since these and other complex, confusing, and limiting factors for defined benefit plans are contained in IRC Sec. 412, the solution is to utilize a plan that is exempt from the funding requirements of IRC Sec. 412.  If a plan meets the requirements of IRC Sec. 412(i), it will be exempt from the section’s funding rules.  For this reason, the 412(i) or fully insured plan deserves a closer look. 

IRC Sec. 412(i) Requirements: 

A defined benefit plan will meet the requirements of IRC Sec. 412(i) if: 

1. The plan is funded exclusively by the purchase of individual insurance contracts.
2. Such contracts provide for level annual premium payments to be paid extending not later than retirement age for each individual participating in the plan, and commencing with the date the individual becomes a participant in the plan.
3. Benefits provided by the plan are equal to the benefits provided under each contract at normal retirement age under the plan and are guaranteed by an insurance carrier to the extent premiums have been paid.
4. Premiums payable for the plan year, and all prior plan years, under such contracts have been paid before lapse or there is reinstatement of the policy.
5. No rights under such contracts have been subject to a security interest at any time during the plan year.
6. No policy loans are outstanding at any time during the plan year.

In a nutshell, if the plan invests entirely in acceptable insurance company contracts and does not allow loans, it can qualify as a 412(i) or fully insured plan, and be exempt from the funding requirements of IRC Sec. 412. 

The advantages of being exempt from IRC Sec. 412 funding requirements need to be fully understood.  This is the appeal of the fully insured plan.  Let’s explore these advantages in detail. 

Advantages of the Fully Insured 412(i) Defined Benefit Plan 

The fully insured plan is not subject to the requirement of making quarterly contributions.  In a traditional plan, these contributions are usually a nuisance for the small business.  The correct amount of quarterly contribution is not always known soon enough to make the first quarterly contribution.  If it is not made, the participants need to be informed or penalties will be incurred.  If the contribution is too small, there will be interest penalties.  If it is too large, a nondeductible contribution penalty may be incurred.  The calculation of the full funding limit may mean no contribution can be made, but that may not be know until later in the year.  Generally, quarterly contributions are an undesired complexity to the small business. 

The mathematical results of the new full funding limitation test may be the biggest problem of all for the small defined benefit plan.  These annual calculations can cause the plan costs to fluctuate greatly.  There may be little or no deduction in one year and then relatively high cost may be required the following year.  Suddenly, the small business loses any handle on what the future cost pattern for the plan may be.  Certainly, unknown costs are an undesirable trait for a small business retirement plan.  Fully insured plans are not subject to the full funding limitation. 

Inadvertent over-funding can occur in a traditional plan for various reasons, including higher than anticipated earnings, new changes in the law limiting benefits, and plan forfeitures.  This can create excess plan assets.  If the plan is terminated with excess assets that will revert to the employer, the plan will pay a 50 percent excise tax on the excess, in addition to income tax on the reversion to the corporation.  The nature of the funding method of a fully insured plan should not create excess assets so there would be no reversion to be taxed and penalized. 

Fully insured plans should not have the actuarial assumptions attacked since the assumptions are mandated to be the guaranteed rates in the insurance company products.  If the benefits must be guaranteed by the contracts, the funding of the contracts must be based upon the guaranteed rates. 

A fully insured plan is not required to file a Schedule B so the service of an enrolled actuary are not necessary for attesting to the funding of the plan. 

Additional advantages of the fully insured plan include: 

• It is more understandable since the participant’s accrued benefit at any point is simply the amount of funds in the insurance company contracts.  Historically, participants find it difficult to understand the pro-rata service or participation accrual definitions of the traditional defined benefit plan.
• Larger overall deductions are allowable because the funding assumptions are based on the contract guarantees.  The lump sum equivalent of the monthly benefit is higher than in a traditional plan and the pre-retirement interest assumption is lower.  The plan still benefits from current earnings, however, as the dividends of the insurance company contracts serve to reduce the next year’s required contribution.  The chart at the end of this article illustrates the initial level of deductions possible in a fully insured plan compared to the traditional defined benefit plan.

In total, these advantages are too important for the small business to ignore.  The investment options are more limited but can be worth the trade-off.  If the overall objective of the small business is a large deduction, a secure promise of benefits, a reasonable market rate of return on investments, more stability, and less complexity, then the fully insured plan has merit.

The cost of the plan remains a relatively know quantity in a fully insured plan.  The traditional defined benefit plan may experience undesirable fluctuations under the full funding limit calculations.  This handle on plan costs enjoyed by the fully insured plan can be one of the most important advantages of all for the small business. 

Speaking very generally, traditional defined benefit plans have fallen into disfavor for the very small business for the reasons stated above.  Unless the owner is at least 45 – 50, a defined contribution plan may have more overall advantages – particularly the New Comparability profit sharing plans now allowed under non-discrimination rules. 

There is still a need for the defined benefit plan for the very small business.  Many times, only a defined benefit plan can meet the objectives of the business owner.  In these cases, the advantages of the fully insured plan deserve close consideration. 

There are relatively few insurance companies that fund and administer fully insured plans.  One reason is that usually standard products would not normally be allowed to fund a 412(i) plan.  A new product would have to be designed, or existing products would need to be amended to comply with the specifics of the 412(i) funding.  Additionally, not many insurance companies market and administer plans for the small business situation.  Usually the funding options for a 412(i) plan would be to totally fund the plan with a fixed annuity, or to fund the plan with a combination of fixed annuity and whole life products.  Variable annuity and universal life products would not have the necessary guarantees to accommodate the funding and benefit requirements of a fully insured plan. 

Conclusion 

To summarize, the future plans of choice for the small business may well be the new comparability profit sharing plan as the defined contribution option and the 412(i) fully insured plan as the defined benefit option.  All small businesses and their advisors should be aware of both types of plans and the advantages of each. 

See the following page illustrating maximum deductions available at selected ages for a 412(i) Defined Benefit Plan.  Also included (as an additional bonus) is an illustration of the allocation possible within a New Comparability profit sharing plan favoring the owner of a small business.

412(i) Fully Insured Defined Benefit Plans 

These plans allow the largest possible deduction for the business owner.  A good candidate for this plan design is an older independent contractor with few employees (or none) and who is earning a very high income.  There is little flexibility in the contribution level each year.  All benefits must be guaranteed by an insurance company so all assets must be invested in insurance company contracts. 

Maximum First Year Deductions Available at Selected Ages: 

 Note:  The contributions above are based upon the guaranteed annuity purchase rates, the guaranteed insurance cash values, and the guaranteed annuity accumulation rates of American National Insurance Company 412(i) qualified life and annuity products.  The numbers also assume the business owner at the selected ages has earnings of at least $140,000.

 New Comparability Profit Sharing Plans 

These plans allow for the largest possible share of the firm’s contribution to be allocated to the owner and/or key employees.  There is flexibility in the contribution level since it is a profit sharing plan and the contribution each year is discretionary.  The plan works best when the business owner is older than most of the other employees.  If maximum results are achieved, it is possible for the business owner to be allocated five times more than the other employees as a percentage of pay (i.e. 25% of salary contributed for the owner and 5% for all other employees). 

OWNER’S SHARE                                            50%                                         83% 

New Comparability Profit Sharing Plan 

The new Comparability Profit Sharing Plan has been available now for more than a decade, but remains one of the most under utilized ideas available to small businesses.  Because it is a profit sharing plan, no contributions are required unless a profit is made.  The advantage that this plan provides is a larger contribution for owners than traditional plans as well as a larger percent allocation for ownership than in other plans.  The relatively new non-discrimination rules make these advantages possible. 

Unlike the 412(i) plan, mutual funds or variable products may be used.  Life insurance can be part of the plan but is not required (however, if life insurance is used it must be funded annually). 

The most likely candidate for a “new comp” prospect is a firm of 40 employees or less with a small ownership group that is slightly older on average than the rest of the workforce. 

This plan allows a dramatically larger percentage of contributions for the highly compensated group (up to 80% or 90% in some small groups).

Defined Benefit Plans for 2001

Maximum First Year Contribution

Normal Retirement Age 65

(or 5 years of participation, if later) 

 Notes: 

1. Monthly benefit assumes a “life only” annuity, annual compensation of at least $170,000, and IRC 415 maximum benefit schedule of $140,000 at Social Security retirement age.
2. Traditional DB funding projections based on 6% pre and post retirement interest rate and UP84 mortality table.
3. 412(i) funding based on ANICO guaranteed annuity purchase rates at normal retirement age, 3% guaranteed interest rate on annuity and ANICO Pension Par Whole Life guaranteed cash values if life insurance is used.
4. Subsequent years contributions for 412(i) plans would be reduced by any excess interest earnings and/or life insurance dividends earned.  Traditional contributions would fluctuate based on actual investment earnings compared to assumed 6%.