Many law-firm partners fill their 401(k) early in the year and still face a large tax bill and a wide gap between what they earn and what they have saved. A cash-balance plan is one of the few tools built to narrow that gap. For older partners, annual contributions can run well into six figures, on top of the 401(k). It is also a real commitment for the firm, with costs and obligations a 401(k) does not carry.
A pension that looks like an account
A cash-balance plan is a defined benefit plan, the same legal family as a traditional pension. But each participant sees a balance, much as they would in a 401(k). That balance is a bookkeeping entry, not a separate pot of money. It grows in two ways each year.
- A pay credit. A set percentage of pay or a flat dollar amount, written into the plan document.
- An interest credit. A rate the plan promises, either fixed or tied to a published benchmark such as a Treasury rate.
The firm funds the plan, not the individual partner. Each year an actuary calculates how much the firm must contribute so the pooled assets can cover the balances the plan has promised. When a partner leaves or retires, the balance is usually payable as a lump sum or an annuity. A lump sum can often be rolled into an IRA. How that works in your case is a question for your accountant.
Why the amounts can be large
A 401(k) caps what goes in each year at the same dollar limit regardless of age. A defined benefit plan is limited mainly by the benefit it may eventually pay, not by a flat yearly cap. The closer a partner is to retirement age, the less time remains to fund that benefit, so the allowed annual credit rises with age. A partner in their fifties or sixties can often receive a credit several times larger than a 401(k) allows. A partner in their thirties gains much less.
In general, contributions are deductible to the firm when made and taxed to the partner when withdrawn. The actual result depends on the firm’s structure, the state and each partner’s own finances. Your attorney and accountant must be part of the decision.
Who it suits
- Partners in their mid-forties and older with high, steady income.
- Partners who already fill their 401(k) and want more tax-deferred savings.
- Firms with a stable partner group that expects to keep the plan for years.
- Firms where staff costs are modest relative to the partner benefit.
- Firms able to make a required contribution in a weak year.
It fits poorly where income swings sharply, where most partners are young, or where a merger or breakup is likely soon. The plan is meant to be permanent. Closing it after only a few years can draw scrutiny from regulators.
What it costs the firm
Several costs are easy to underestimate.
- Staff benefits. To pass nondiscrimination testing, the firm usually must give meaningful benefits to associates and staff, through this plan, a profit-sharing plan or both.
- Administration. Annual actuarial work, government filings and a plan document kept current.
- Investment shortfalls. If plan assets earn less than the promised interest credits, the firm makes up the difference.
- Insurance premiums. Some plans pay premiums to the Pension Benefit Guaranty Corporation. Certain small professional-service plans are exempt.
- Fixed obligations. Required contributions are not optional in a bad year.
Then there is the internal question of who pays. Partners near retirement benefit most. Younger partners may carry part of the staff cost and any shortfall. The partnership agreement should spell out how plan costs are shared, and it should do so before the plan is adopted.
How the money is invested
Because the plan promises a specific interest credit, the usual aim for the assets is to track that credit closely rather than reach for more. Gains far above it build a surplus that can be hard to use. Losses below it turn into firm contributions. That calls for a written investment policy for the plan itself, tied to the crediting rate and the ages of the partners, and reviewed when either changes.
In our view, the plan should also be weighed alongside each partner’s personal portfolio. A cash-balance balance behaves something like a bond holding, and it changes what the rest of the partner’s money needs to do.
Questions for the actuary
- How is the interest crediting rate set, and what happens if assets fall short of it?
- What will staff benefits cost each year, and how does that shift as headcount and ages change?
- What range of required contributions should we plan for after a bad market year?
- What happens when a partner leaves, retires or joins laterally, or the firm merges?
- How long should the plan stay open, and what does closing it involve, including any surplus?
Ask also what the actuarial and administrative fees are, and whether the plan will need insurance coverage.
Where an adviser fits
A cash-balance plan involves an actuary, a plan administrator, an attorney and an accountant. An investment adviser’s part is narrower: writing the plan’s investment policy, coordinating with the others, and placing the plan within each partner’s wider balance sheet. Plan assets should sit with an independent qualified custodian. Our fees are described in our Form ADV.
This article is for informational purposes only and is not investment, legal or tax advice, nor a recommendation to buy or sell any security. All investing involves risk, including loss of principal.
This material is for informational purposes only and is not a recommendation to buy or sell any security. All investing involves risk, including loss of principal.