The Tax Code permits benefits in a Defined Benefit plan to be based on a High 3-Year Average Pay, averaged over 3 consecutive years at any time during an employee's tenure. Past, current, or future compensation may be used. This can be a powerful cash flow management tool.
Past Pay History
A 3-year average of past pays can be used to provide the basis for projected future benefits and current contributions needed to fund those projected benefits. Thus it is possible to support a large current contribution even though current compensation can be $0. Note that this is in sharp contrast to Defined Contribution Plans, which must always limit current contributions based on current compensation.
Example: Consider an owner, R.A. Pidly , age 60, setting up a Defined Benefit plan in 2004 for a business he established in 1999. Revenues have grown exponentially, and he expects over $200,000 positive cash flow this year, which is available to split between compensation and retirement plan contribution. His wife has a sizeable income that is sufficient to cover all current living expenses, so they agree that he could potentially reduce his take-home pay for 2004 to $0, making all 2004 current cash flow available for a plan contribution.
His 3-Year Average Pay is determined as follows:
Last 3-Year Average
That is, according to the table above, the owner's 3-year average pay is "locked-in" at $100,000 based on his pay history from 2001 to 2003, and this average pay can be used in the plan benefit formula even if he takes $0 compensation for 2004.
U sing DBQuickQuote or looking at the DBMinMax Table for 2004, we immediately see that he has the opportunity to contribute a maximum contribution of $201,538 for 2004. This will also be the approximate amount he can contribute for the next 5 years, cash-flow permitting, whether or not he takes home any additional W-2 pay.
During any years that the firm may experience unexpected financial stress prohibiting a contribution of $201,538 or more, steps can be taken by the actuary to reduce the maximum contribution to lower levels.
In many other situations, the current compensation is higher than for past years, and this current higher pay level is projected into the future to support a projected 3-Year Average Pay equal to the current pay. Thus the current compensation level becomes the sole support for the highest possible level of contribution.
Also, if there is no past pay history, or if the Plan document specifies that past pay history is to be ignored, then fluctuations in pay for the early years of the plan can create appropriate fluctuations in the contribution pattern as well.
Example: Ms. Greene, an entrepreneur age 43, started a new business in 2003 with substantial cash flow over $220,000. She also established a Defined Benefit plan for the year. From the DBMinMax Tablefor 2003 we can see that her maximum contribution was $98,500 to a new Defined Benefit plan. She took $121,500 as her W-2 compensation for 2003, and made the $98,500 contribution to the plan on January 1, 2004.
In 2004, however, her cash flow is reduced substantially to $30,000. The actuary determines two possible funding strategies for 2004:
Using the same assumptions as for 2003, the cash flow can be split as:
$21,501 in compensation
$8,499 in contribution
The High 3-Year Average Pay is calculated to be $54,834 (= ($121,500 (2003) + $21,501 (2004) + $21,501 (projected for 2005)) / 3).
Alternatively, by adjusting assumptions slightly, the cash flow can be split as:
$30,000 in compensation
The High 3-Year Average Pay is calculated to be $60,500 (=($121,500 (2003) + $30,000 (2004) + $30,000 (projected for 2005)) / 3).
In the end, Ms. Greene chooses the second alternative and pays herself $30,000, having a $0 required contribution based on the adjusted assumption basis.
Then in 2005, cash flow again increases significantly, and she wants to make the maximum possible contribution. Assets have grown to $103,425. Lets consider the calculations under two alternative scenarios:
Suppose cash flow has increased to $100,000. She can split the cash flow as:
$35,044 in compensation
$64,956 in contribution
The High 3-Year Average Pay is calculated to be $62,181 (= ($121,500 (2003) + $30,000 (2004) + $35,044 (2005)) / 3).
Suppose cash flow has increased to $200,000. She can split the cash flow as:
$94,421 in compensation
$105,579 in contribution
The High 3-Year Average Pay is calculated to be the higher of:
$94,421 (current compensation projected into the future)
If future cash flow stabilizes at one of these two levels, then future contribution levels will also stabilize.
In the case where annual cash flow is about $100,000, the contribution of about $65,000 will always be based on an historical 3-year average from 2003-2005.
In the case where annual cash flow is about $200,000, the contribution of about $106,000 will be based on a projected 3-year average of about $94,000, or, after 2007, it will have been "locked-in" as an historical average from 2005-2007.
Actuarial s tandards of practice permits the general recognition that future salaries will increase. These future increases are modeled by a Salary Scale of a certain percent increase per year. This Salary Scale must be assumed to be less than the assumed rate of asset growth. For conservative assumptions where the assets are assumed to grow at 5% per year, this means that the Salary Scale is bounded by 5% growth.
In many situations where an historical high 3-year average pay has been locked-in, the presence of a Salary Scale has no effect, because projected future salaries still do not exceed the 3-year average already established.
In addition to salaries increasing in the future, the limits imposed on benefits and contributions by the Tax Code also can be expected to increase. The Tax Code does not permit any assumption on these future increases, but only permits recognition of the increases in the year in which they take effect. This means that the question "What is the minimum compensation to get the maximum contribution?" has an answer that will increase in the future. Hence, if an entrepreneur's goal is to establish a high 3-year average that will support the maximum contribution for many future years, they may want to aim higher than the minimum that is needed for the current year. This will permit the locked-in average to serve for some future years, even after future inflationary adjustments have been recognized for the benefit limits.