Navigating the retirement plan maze
Law firms weighing their retirement plan options face some tough decisions. Many firms have unfunded or underfunded nonqualified pension plans that place a heavy burden on younger partners. This has led some firms to make the transition to defined contribution qualified plans, such as 401(k) and profit-sharing plans. Other firms are looking to defined benefit qualified plans because they can allow larger contributions for older partners. There are several issues to consider if your firm is trying to decide whether to change its retirement plan offerings.
Nonqualified: Flexible but risky
Traditionally, many law firms have opted for nonqualified offerings because they’re flexible. Although they don’t enjoy the tax advantages of qualified plans, they give a firm considerable leeway in designing a plan that fits its organizational structure. With a nonqualified plan, your firm is free to determine which attorneys and staff receive benefits and how much.
At the same time, nonqualified plans present some drawbacks and risks. For example:
- Benefits aren’t deductible by your firm until they’re paid out to retirees.
- If your firm funds the plan through a protected trust, the benefits are immediately taxable to the participants even though they won’t receive them until years — or even decades — later. Therefore, nonqualified plans typically are unfunded to avoid current taxation.
- If your plan is unfunded, younger partners bear the burden of funding future retirement benefits out of future profits to which retired or retiring partners haven’t contributed.
- It’s possible your firm won’t be in a financial position to pay retirement benefits when partners and other employees are counting on receiving them.
There are techniques for setting aside money for future benefits without creating a “funded” plan. For example, your firm might establish and contribute to a “rabbi trust,” which helps ensure that funds will be available to pay out benefits. However, the trust assets remain subject to claims by your firm’s creditors, so benefits could be lost should your firm run into financial trouble or file for bankruptcy protection.
Qualified: Inclusive but limited
Recently, defined contribution qualified plans have become popular with law firms and their nonpartner staff. They have some significant benefits:
- Firm contributions are currently deductible by your firm.
- Employees can also contribute, and these “deferrals” generally are pretax.
- Both firm and employee contributions grow tax-deferred until they’re distributed.
- Plan assets are held in a trust account that’s protected against creditors and bankruptcy.
But because most firms have multiple classes of plan participants — equity and nonequity partners as well as several categories of attorney and nonattorney employees — it can be challenging to design a defined contribution qualified plan that conforms to various limits and requirements and still meets the needs of the partners.
Qualified plans are heavily regulated and must comply with all Employee Retirement Income Security Act (ERISA) requirements. For example, they’re subject to strict contribution and benefit limits, minimum coverage rules and funding requirements. And they must be tested annually for nondiscrimination. This means that benefits for highly compensated employees (as a percentage of compensation) can’t be significantly higher than those for other employees.
Also, your firm and its retirement plan committee (which should be independent of your firm’s management committee) are considered ERISA fiduciaries. They must exercise due diligence in selecting plan vendors and investment advisors, must act in the best interests of the participants, and are personally liable for breaches of these duties.
Turbocharging partner benefits
Perhaps the biggest disadvantage of defined contribution qualified plans is that nondiscrimination requirements and contribution limits can make it difficult to generate sufficient benefits for partners, particularly those approaching retirement age. For example, the current combined limit on firm contributions and employee deferrals is only $52,000 annually ($57,500 for participants over 50).
To address this drawback, many law firms are adopting defined benefit qualified plans — often as a supplement to a maxed-out 401(k) or profit-sharing plan. Contributions to defined benefit plans are deductible by the firm and, as the name suggests, are actuarially calculated to fund a particular annual benefit at retirement. (The current benefit limit is $210,000.) This enables the firm to make contributions of as much as $200,000 or more per year on behalf of older partners closer to retirement and relatively modest contributions on behalf of younger partners and other employees.
If you’re considering offering a defined benefit plan, know that annual firm contributions are required regardless of your firm’s financial performance. Unlike 401(k) and profit-sharing plans, defined benefit plans can’t reduce or suspend firm contributions in tough times. So you must have confidence in your firm’s ability to meet its funding obligations over the years.
Consider a cash balance plan
One way to enhance retirement benefits for your firm’s partners is to offer a cash balance plan. Technically a defined benefit qualified plan, a cash balance plan often is described as a “hybrid” because its benefits are expressed as account balances, much like a defined contribution plan.
A drawback of traditional defined benefit plans is that benefits, typically based on a percentage of final compensation, are somewhat uncertain. With a cash balance plan, however, your firm allocates annual pay credits and interest credits to participants’ “hypothetical” accounts, making benefits easier to understand. Pay credits are a percentage of compensation or a fixed dollar amount, while interest credits are based on a fixed rate of return or an indexed rate, such as a 30-year Treasury rate.
In 2010, the IRS approved the use of “market-rate” cash balance plans. Their interest credits are based on the actual performance of plan investments, making contributions more stable and predictable.
Review your options
Choosing and administering a retirement plan is complicated. To design a retirement benefits strategy that takes into account your firm’s makeup and needs, work with experienced advisors. If you currently have an unfunded nonqualified plan and you’d like to continue offering it, your advisors can help you devise strategies for reducing financial risks.