Professional Groups

Art by Melinda Beck

Professional groups such as law firms, engineering firms and medical practices have unique and potentially competing needs for their retirement plan. The highly compensated owners’ main worries are saving enough for retirement and reducing their tax liabilities, but they are also concerned about their employees.

“Aside from their wanting to save adequately for their own retirement, in many cases, the practice may feel like a family to them,” says Amy Ouellette, head of operations at Betterment for Business in New York City. “Say the business is a medical practice; the doctors may want to treat their employees as well as they treat their patients.”

So, the first thing a retirement plan adviser should do when starting to work with a professional services firm, says Tom Foster, head of strategic relationships for retirement plans, at MassMutual in Shelton, Connecticut, “is to do [his] homework and get to know as much as [he] can about the employer and its existing retirement plan.” MassMutual recommends using Planisphere, a service that culls data from the Form 5500 that retirement plan sponsors annually file with the Department of Labor (DOL). It will let the adviser know the size of the employer, how many employees it has and what type of retirement plan(s) are in place, Foster says. Form 5500 search engines are also available from BrightScope and Benefits Pro.

The next thing advisers need to do is ask the owners which employees they most want the plan to benefit and the average age of those who are highly compensated, Foster says. This will help the adviser determine what type of retirement plan would best suit the organization. Advisers should then work with a third-party (TPA) administrator to run the numbers on different approaches to the retirement plan design, he adds.

But advisers going down this path should do their homework on the TPAs they consider partnering with, as well. The TPA must be familiar with advanced plan design approaches, such as age-weighted, cross-tested and cash balance plans. “Not all TPAs are experienced in doing that,” says Lori Reay, a partner with DWC – The 401(k) Experts, a TPA firm in St. Paul, Minnesota. Advisers should ask the TPA about his book of business before hiring him to help with a professional services company, she advises.

Professional services firms are not typically served by retirement plan specialists, says Phil Fiore, CEO of Procyon Partners, also in Shelton, Connecticut. “If the adviser suggests a redesign, it can help the owners put away significantly more money for their retirement, and truly be life changing for someone making $1 million to $2 million a year, as that person will need considerably more than what a 401(k) plan will allow” him to save, Fiore says.

The amount that a highly compensated employee (HCE) will need in order to replace the recommended 75% to 80% of his income in retirement is substantial, says Chris Foster, managing director at Procyon, and this is what advisers must keep in mind when suggesting various approaches to a professional services firm.

Safe Harbor Plans

Typically, the first place to start is to offer a safe harbor 401(k) plan so that the HCEs can maximize their contributions, Ouellette says. The Internal Revenue Service (IRS) currently allows those under age 50 to contribute up to $18,000 a year in their 401(k) and those 50 and over to save an additional $6,000 a year, for a total of $24,000. However, for them to do so, the plan must pass discrimination testing, which can be achieved by making it a safe harbor plan through three options. The first is to give a safe harbor match of at least 4% of salary to participants. The second is to donate a 3% or more nonelective contribution to all eligible employees, and the third is to donate a 3.5% or more qualified-automatic-contribution-arrangement match in tandem with automatic enrollment.

Another way that a plan sponsor may better pass the discrimination testing is to limit the group considered to be highly compensated, Ouellette says. When limiting the highly compensated group to the top 20% of earners, the employer may increase the number of non-highly compensated employees able to maximize contributions, improving test results. It also limits the effect of a failure to fewer top-paid employees, she says.

A further common approach advisers take with professional services firms is to pair a 401(k) plan with a profit-sharing plan, which permits a participant to generate up to $60,000 a year in savings, when factoring in voluntary contributions, employer contributions and age-restricted catch up contributions, says Foster of MassMutual. Many advisers also suggest a cross-tested, or new comparability, plan, he says. This is a type of profit-sharing plan that permits the sponsor to divide employees into different groups and project what a current contribution would amount to at each group’s retirement age, he says. Thus, younger employees with a longer investment horizon would receive less than older employees closer to retirement, he explains. The maximum that may be contributed is $54,000, and the minimum that the sponsor must give to the non-HCE workers is either 5% of pay or one-third of the amount allocated to the most highly compensated worker, Foster says. The contributions to non-HCEs are quite generous, when compared with the typical company matches a sponsor makes to a 401(k), making cross-tested plans a “win-win” for HCEs and non-HCEs alike, he says.

Cash Balance Plans

Ray Kathawa, vice president of practice development at M&O Marketing in Southfield, Michigan, recommends two further plan options for professional services firms: solo 401(k)s and simplified employee pension (SEP) individual retirement accounts (IRAs). The solo 401(k) allows the business owner to contribute the IRS limit of $18,000—or $24,000 for those 50 and older—plus 25% of compensation, and the SEP IRA permits contributions of 25% or compensation or $54,000, whichever is less, Kathawa says.

Yet, while these contributions may seem sizeable, for someone earning multiple millions a year, they may still be falling short, says Jake Serfas, lead financial strategist at O’Dell, Winkfield, Roseman & Shipp (OWRS) in Washington, D.C. He, therefore, recommends an executive bonus plan based on Section 162 of the IRS tax code. This allows a company to give its HCEs a bonus of up to several million dollars a year inside an insurance policy with guaranteed principal protection, Serfas says.

The money grows against a market index, although the gains may be capped, perhaps at 10%, Serfas says. The balance will increase, tax deferred, and if the withdrawals are in the form of a policy loan, they can also be income-tax-free, he says. There are no limits on how much may be contributed to the policy each year or how much may be withdrawn, he says. Among his clients, the employers contribute between $60,000 and $3 million a year to such insurance policies for their executives.

A proponent of insurance policies, Serfas says he also recommends fixed-income annuities to his professional services clients. “My clients don’t want to lose money, and annuities give you full principal protection,” he says. “To determine how much they should contribute to an annuity, I ask my clients what percentage of their portfolio they want to make safe and how much of a paycheck they want to derive from [that]. I then calculate what is the least amount of money that should go toward the annuity.

“Many of my clients previously had financial advisers who told them to put every single dollar into the market,” he continues, “but I believe they need a combination of market-based and insurance-based products. Insurance products give you guarantees and sustainability of income, while market-based products keep up with inflation and allow you to pursue other opportunities.”

Defined benefit (DB) plans can also make sense for professional groups, says Josh Sailar, an investment adviser with Miracle Mile Advisors in Los Angeles. “This is especially true when you have highly compensated older leaders and younger, lower-compensated individuals among the rank and file,” Sailar says. “Defined benefit plans can be an extremely powerful way for professional services executives to save adequately for their retirement. Net of taxes, [they are] a great way for a company to extract value from its cash flow, retain employees and attract employees.”

Sailar also believes that, with the help of their advisers, professional services executives are better positioned to manage the investments in a DB plan profitably, and he says he likes such plans because they “can provide an exponentially greater benefit than a DC [defined contribution] plan.”

Lori Shannon, a partner with Barnes & Thornburg in Chicago, is equally enthusiastic about recommending DB plans to professional services firms. Many of her law firm clients couple a DC plan with a DB plan to maximize tax deferrals. “Even though DB plans can be very expensive and perhaps not the right choice for larger employers, for smaller professional groups with younger rank-and-file employees, DB plans can be structured to provide greater benefits for key employees—typically $100,000 or more in tax-deferred contributions each year—and 5% to 8% of compensation for the rank and file,” Shannon says.

In addition, the sponsor has the right to decide whom to include in the DB plan without the IRS considering that discriminatory. For example, “associates or juniors may not be eligible,” she says.

For those professional services firms that consider cross-tested or defined benefit plans too complicated, there are always nonqualified deferred compensation (NQDC) plans, Shannon says. The employer may decide to whom to offer the NQDC plan, she says. While the IRS has no restrictions on how much money a nonqualified plan participant may set aside, some plans have a contribution limit.

Some employers find NQDC plans give highly compensated employees an additional incentive to remain with the company, says John Dulay, a financial adviser with Raymond James & Associates in Chicago.

However, the assets in the NQDC plan are general assets of the company and are subject to the employers’ creditors, Shannon points out.

Moreover, according to Chad Johansen, director of retirement sales at Plan Design Consultants Inc., a third-party administrator in San Mateo, California, while a company gets a tax deduction for its funding of its 401(k) and profit-sharing plans every year, with an NQDC plan the deduction comes only when a participant takes his money.

Aside from helping professional services companies design a robust retirement plan, Kathawa recommends that advisers suggest their professional services clients take out disability and key person insurance.

MassMutual’s Foster agrees, noting that working with a sponsor on all of its benefits can help strengthen the retirement plan. For instance, by offering employees accidental and disability insurance, the sponsor can help prevent leakage from the 401(k), he says.

Kathawa has also found that advisers have an advantage when offering wealth management services to the professionals “because people want to keep things simple and have one person manage their accounts.”

According to Sailar, many of his professional services clients ask him to manage their entire savings, not just their retirement accounts. “When you have a pass-through entity, the line between where business ends and the personal begins is porous,” he says. “They appreciate our approach because we do planning on both sides of the fence, and it is personal.”

KEY TAKEAWAYS:

Before working with a professional services firm to design an effective retirement plan, it is imperative that an adviser know the demographics of the HCEs and whom the owners want to benefit the most.

The first logical step is to make the 401(k) plan a safe harbor plan, so it is possible for the HCEs to maximize their contributions.