Cross-tested Profit Sharing Plans: A Valuable Tool for Small to Mid-Size Firms
By Harry Veldkamp
Small to mid-size professional services firms often do
not realize one of the significant advantages they enjoy
over their larger competitors. Smaller firms have the ability
to be flexible in the design of their retirement plans to
help retain, reward, and attract prospective employees in
a way that larger companies with “normal” plans
cannot match.
Large firms’ retirement plans tend to be “one
size fits all,” with everyone generally subject to
the same benefit formula or allocation, usually expressed
as a percentage of pay. Smaller firms, on the other hand,
may treat individuals within the company differently, rewarding
them based on a variety of factors most important to the
firm.
“Cross-tested” Plans: The Small Firm
Edge
There are several types of retirement plans available to
professional services firms, such as Defined Benefit, 401(k),
and Profit Sharing plans. One type of plan that has been
used to great advantage by smaller firms is a hybrid form
of a Profit Sharing plan known as a “cross-tested”
plan. Cross-tested profit sharing plans, also known as “new
comparability” or “multiple-tiered” plans,
allow firms to meet the needs of most, if not all employees.
In addition, a well-designed cross-tested retirement plan
can be a more visible and valued employee benefit than a
traditional plan.
A cross-tested plan allows a firm to place each eligible
participant into his or her own “tier” and the
firm then determines on a year-by-year basis how much is
contributed on behalf of each individual or group of individuals.
Tiers can be based on a variety of factors, including compensation,
longevity on the job, meritorious service, attaining certain
sales and/or managerial goals, to name just a few. Using
these plans, a business can tailor its total compensation
and benefit package to meet individual needs and provide
a vastly more meaningful benefit to employees and especially
to key individuals.
Companies that have owners with different objectives often
use cross-tested plans to meet their needs. Many times the
owners have the same overall compensation, but one owner
might prefer to contribute less to the retirement plan while
another owner choose to put more money into the plan. Often
the result is a compromise where each owner is equally dissatisfied.
The ideal solution in these situations is to implement a
cross-tested plan, because each owner can then achieve his
or her desired result, rather than settling for a compromise.
Many management consulting firms favor cross-tested plans
because they provide the opportunity to reward certain consultants
more than others based on their performance. For example,
consultants bringing in more new business than others can
be suitably rewarded—instead of or in addition to
other incentives—using the cross-tested approach.
Similarly, firm partners can have contributions allocated
to themselves in the same ratio as, for example, their stock
ownership or contributions to the success of the practice.
It is important to note that, while the cross-tested allocation
approach would not be a complete replacement for a direct
bonus (whatever the tax consequences), it is a welcome contribution
that hopefully will yield years of tax-deferred growth for
the employees who are focused on planning for retirement.
For example, if an employee receives a $1,000 bonus, which
after taxes amounts to about $700, it is likely that the
bonus will be spent rather than saved. However, $1,000 contributed
to a profit-sharing plan for twenty-five years compounded
at 8 percent interest would yield approximately $73,000.
For the business owner, it is not unreasonable for a successful
person to personally put away the maximum of $44,000 per
year. Do this for fifteen years at 8 percent interest and
you will have some serious money at retirement: approximately
$1.2 million. If you can do it for twenty years, you will
have more than $2 million.
Different Goals, Targeted Benefits
The unique features of cross-tested profit sharing plans
can be demonstrated in the following examples involving
four hypothetical small to mid-size businesses and the approaches
they took.
Consulting Firm A adopted a cross-tested profit sharing
plan, with each participant in his or her own tier, for
the express purpose of acquiring exceptional personnel for
highly technical positions. Normally, relatively older and
more experienced personnel would fill these positions, with
pay in the $70,000 to $85,000 range.
The cross-tested plan provided Firm A with the opportunity
to tailor retirement benefits to each qualified applicant,
developing different profit-sharing benefits, in its sole
discretion, to allow for flexibility in hiring. At the same
time, Firm A’s larger competitors were required to
make the same contribution percentage for all their participants.
Note that it was much less costly to Firm A and the participants
to have the company make these tax-deductible contributions
to the profit-sharing plan than to pay the same amount in
taxable bonuses.
Consulting Firm B carried this idea one step further. It
was facing a retention problem and wanted to stem the costs
of hiring and training replacements for these well-qualified
employees. Under the cross-tested approach, certain participants
whom Firm B determined were more valuable were granted higher
percentage of pay contributions based on both their longevity
with the firm and their overall contributions to its success.
A case study: assume Consulting Firm C has one principal
and ten non-highly-compensated employees. The principal
earns $220,000 and defers $15,000 into the Firm’s
401(k) Plan. The deferral percentage for the principal is
6.82 percent. Therefore, the other eligible employees defer,
on average, 4.82 percent. However, if the principal needs
to defer only $9,000 to reach the full $44,000 annual addition,
the deferral percentage is reduced to 4.09 percent, so the
other eligible people need only defer, on average, 2.05
percent, which is much easier to accomplish.
In another instance a tax-exempt entity decided to encourage
its employees to contribute to their individual 403(b) plans
and to reward them for longevity. Although these employees
were not highly paid, they were very valuable to the employer
and provided valuable services to the community. It is difficult
to obtain such dedicated individuals and, unfortunately,
economic pressure forced some of these employees to leave
for higher paying jobs.
The solution for the employer was to adopt a cross-tested
plan, which allocated the contributions based on a) the
amount each employee contributed to the 403(b) program and
b) the longevity of the participant. For example, if participant
A did not contribute to the 403(b) plan and was with the
organization for less than five years, the contribution
would be 1.5 percent of pay. If the 403(b) contribution
for that same individual were 5 percent of pay, the organization
would “match” $0.50 on the dollar up to 6 percent
of pay through the separate tiered-allocation program. The
percentage amounts of the “match” would be increased
based on the rate of contributions to the 403(b) program
and longevity. This program has been in effect for several
years and has been expanding.
Conclusion
Cross-tested plans are a great solution for many small
to mid-size management consulting firms, but they are not
“cookie-cutter” plans and they require experts
to establish an optimal plan design and perform the necessary
annual plan administration and calculations. Equally important
is an annual review to insure that the plan continues to
provide its intended results for the firm, its principals,
and its employees.
Each business is different and requires an individual analysis.
IRS non-discrimination tests must be met, but cross-tested
plans feature flexibility that can provide great solutions
for small businesses. Cross-tested plans take a little more
work to establish, but their benefits can be exponentially
greater than those of a “normal” retirement
plan.
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Harry Veldkamp is co-owner and CEO of Polycomp
Administrative Services, Inc., a California-based consulting
leader in providing customized retirement plans and benefit
administration since 1974. He can be reached at hveldkamp@polycomp.net
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