A Tiered Defined Benefit Plan (Tiered DB Plan) is a Defined Benefit Plan that permits a targeted, individualized benefit for each Highly Compensated Employee (see definition of HCEs ). These individualized benefit levels create different benefit "tiers" within the plan, hence the term "Tiered Defined Benefit Plan."
A group of professionals numbering from two to several hundred can be included in one plan, yet with different benefit levels for each. These plans can be very attractive to Medical Specialty Practice Groups or any other professional group with a high concentration of Highly Compensated Employees, such as Attorneys, Architects, Certified Public Accountants, and Engineers.
Tiered DB Plans permit maximum flexibility in the contribution level for each professional. In the example below, Doctor A contributes $201,538 while Doctor D contributes $0. The amount of contribution for each professional is supported by her/his current and past compensation, and is more extensively discussed below.
In addition to contributions made to the Tiered DB Plan as illustrated in the table below, professionals can adopt a 401(k) Deferral-Only Plan, and defer as much as $16,000 in 2004. Each participant has the choice to contribute these additional deferral amounts at their discretion. Opting only for the 401(k) deferrals may have been the preference of Doctor D in the illustration below, who specified $0 benefits in the Tiered Defined Benefit Plan.
How Tiered Defined Benefit Plans Work
Compensation, Contributions, and Benefit Limits
Current and past compensation support the contributions. In 2004 the maximum compensation that can be counted is $205,000.
The highest consecutive three years of compensation--past, present, and projected--support the highest possible contribution. For example, $165,000 average compensation for 2001, 2002, and 2003 can support the maximum benefit and contribution level for 2004, and at the same time, the compensation for 2004 can actually be $0. In other words, it is possible for the contribution level to greatly exceed the current compensation.
Equity among Individual Participants
A Tiered Defined Benefit Plan is designed to closely track each professional's relative interest in plan assets based on her/his contribution to these assets. This parity is not automatic due to the complex nature of the plan, but must be carefully structured into the design of the plan. There are three points at which parity can be addressed and achieved:
(1) Parity between Contribution and Benefit Levels Proper provisions must be adopted within the plan to ensure that there is as-close-as-possible tracking between the benefits earned by each HCE and their contributions made:
Vesting is 100% Immediate
Credited Service is based only on Participation (no Pre-participation Service is counted for Accrual purposes)
Lump Sum benefits are permitted and encouraged (by not offering a large selection of annuity options)
Death Benefit equals the Present Value of Accrued Benefit
In most cases, as of the end of the first year, the Contribution level is greater than the Present Value of Accrued Benefit leaving no unfunded Present Value of Accrued Benefit
(2) Truing-up at Termination of a Plan Participant There will always be some disparity between the contribution and benefit levels for each participant. This disparity arises from the difference between
the actuarial methods involved in determining the present value of benefits, as opposed to
the amortization procedures of funding calculations,
different actuarial assumptions that are mandated,
gains and losses due to investment earnings, and
In order to account for the accumulated cost of each participant, the contributions, along with asset gains and losses, must be tracked for each participant. After an HCE withdraws from the group, the distribution will be trued-up with the contribution by several possible steps:
In most cases the accumulated cost will exceed the distribution amount. To the extent permitted by statutory limits, the participant can receive an increased distribution amount that equals the accumulated cost.
To the extent that the statutory 415 limit does not permit an increase of the distribution amount, the difference between cost and distribution can be recognized outside of the plan.
Similarly, if the distribution amount exceeds the accumulated cost, the difference can be recognized outside of the plan.
(3) Allocation of Gains and Losses Asset gains and losses are allocated within the plan according to prior costs and allocated assets. This means that actuarial gains (rates of return that exceed the assumed 5% rate of return) will tend to reduce future contribution requirements. On the other hand, actuarial losses (for rates of return below 5%) will tend to increase future contributions. Contribution levels can be further adjusted by periodically adjusting the benefit level for a participant to the extent permitted by 415 and other statutory limits.
Internal Revenue Service Rules for Participation, Coverage, and Non-Discrimination
In order for a Tiered Defined Benefit Plan to be feasible, certain key hurdles must be met in order to deem the plan to be non-discriminatory.
(1) Participation under Section 401(a)(26) of the Code All Defined Benefit Plans (including Tiered DB Plans) must cover at least 40% of employees who are age 21 and meet a 1-Year of Service requirement. Alternatively, a DB plan may cover at least 50 Participants. This is the first criterion that a Tiered DB Plan must meet.
(2) A Profit Sharing Plan for Non-Highly Compensated Employees cross-tested under Sections 410(b) and 401(a)(4) of the Code To pass non-discrimination and coverage requirements, the Tiered DB Plan is combined with a Profit Sharing Plan covering Non-Highly Compensated Employees (NHCEs). Together the combined plans must pass both the 410(b) coverage and the 401(a)(4) non-discrimination tests. Generally, these tests can be passed by providing a 7.5% to 15% of pay allocation to the NHCEs in the Profit Sharing plan.
The Profit Sharing Plan for the NHCEs may also include a 401(k) Deferral Provision so that the NHCEs can defer up to $16,000 in 2004.
Pension Benefit Guaranty Corporation
Professional entities establishing a defined benefit with 25 or fewer participants are not subject to the payment of premiums to the Pension Benefit Guaranty Corporation (PBGC). For larger groups the annual premium is $19 for each participant. There is the potential for an additional Variable Rate Premium, but this risk is managed through plan design and funding methodology, and is generally non-applicable.
Summary and Conclusion
Professional groups not pleased with the limited contributions of defined contribution plans and uncomfortable with the inflexibility of a traditional defined benefit plan for a group of Highly Compensated Employees (HCEs) in the aggregate may find the Tiered Defined Benefit Plan to be the best approach to meeting their needs.
Tiered Defined Benefit Plan Example
This sample Tiered Defined Benefit Plan (Tiered DB plan) covers 5 Highly Compensated Employees (HCEs). The basic Benefit Formula is chosen to produce the maximum possible benefit and contribution level for each doctor--unless she/he has chosen a lower level of benefit. Retirement age is age 62 with 10 years of participation in the plan. The lower benefit level can be $0 if desired and if 401(a)(26) Participation requirements (discussed above) are not adversely affected.
Benefit Plan 2004
As % of
* Certain of these amounts are based on the maximum limits for 2004, and may be expected to increase in future years. Doctor D has opted out of the defined benefit plan at this time, but can join the plan later, and in the meantime he can defer $16,000 in 2004 in the 401(k) plan.