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412(i) PLANS: WHY SO POPULAR?

WHAT IS A 412(i) PLAN?
A 412(i) plan is a form of defined benefit pension plan. It’s an employer-sponsored retirement plan that promises an employee that, upon retirement, he or she will receive a specific benefit amount annually (or more frequently) based on a formula that considers compensation, years of service, or both.

A 412(i) plan (a/k/a a fully insured plan) is a form of defined benefit pension plan funded exclusively by life insurance or annuity contracts.

These fully insured plans receive special treatment under Internal Revenue Code Section 412(i) – which is why they are called “412(i) plans.”

WHY ARE DEFINED BENEFIT PENSION PLANS BECOMING SO POPULAR?
Here are some of the many reasons why 412(i) plans may be of interest to you – or to someone you know:

First, tax law reflects real life. There’s a pendulum which swings back and forth in synchronization with the economy and stock market. It is currently swinging away from the all-out optimistic “go-go” or “everyone’s getting rich and you can’t lose on stocks” mind set, and toward a more conservative thinking that emphasizes certainty and guarantees. What people want most of all right now is not a return on their investments as much as a return of their investments. 412(i) plans provide that security, since, by design and definition, they are fully insured. Risks are shifted from employers to state licensed and well financed insurers.

Second, aging baby-boomer business owners are finding that 412(i) plans favor them as older and long-service employees.

Third, a 412(i) plan allows significantly greater contribution levels than a normal defined benefit plan.

Fourth, 412(i) plans minimize risks. Because a third party, the insurer, guarantees all benefits, assuming premiums are paid when due, the employer’s investment risks are minimized.

Fifth, these plans are generally easier and less expensive to administer than many other types of retirement plans. Administration costs can be significantly lower in a 412(i) plan because there are no direct actuarial fees and many IRS rules that other retirement plans must meet.

Sixth, it is relatively easy to calculate and explain the benefits.

WHAT ARE THE PITFALLS, COSTS, AND DOWNSIDES OF 412(i) PLANS?
No planning tool or technique is perfect or without costs or downsides. Here are the main issues:

First, compared to certain other alternatives, a 412(i) plan is more conservative and provides less upside potential for growth.

Second, compared to certain other alternatives, the 412(i) plan provides less investment and plan design flexibility.

Third, a 412(i) plan is not permitted to make loans to plan participants.

Fourth, initial costs may be higher than for noninsured defined benefit plans.

So the clear “upsides” are the use of 412(i) as a tool for maximizing contributions and guarantees as well as the simplicity and relative safety.

The clear “downsides” are limited investment growth potential and plan design flexibility.

WHEN SHOULD A 412(i) PLAN BE CONSIDERED – AND BY WHOM?
An employer should consider a 412(i) plan if:

• the employer wants to maximize its initial rate of contribution,
• the employer is in a good current financial condition,
• substantial early funding is preferable for any reason,
• the firm has no more than 10 employees, or
• contributions to an existing, conventionally funded defined-benefit plan have been severely reduced by the tax law restrictions on actuarial assumptions or by the full funding limitation.

Please feel free to contact us to discuss this or other concepts that might enhance the financial security of your business, your family, or aid the charity of your choice.