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By Jonathan Porter, Esq
Director
Three Bridge Wealth Advisors


Utilization of Defined Benefit Plans in PE Firms

Recent changes in retirement plan laws have created a significant opportunity for venture capital and private equity firm general partners to substantially increase their pre-tax retirement contributions without appreciably increasing contributions to non-partners. In so doing, general partners can minimize the taxes they pay up-front on their management fees, and at the same time maximize their retirement plan savings in a tax-deferred environment.

In addition, private equity professionals will be subject to a number tax increases beginning as early as 2011. Income taxes, long term capital gains, and dividend taxes are all increasing next year by operation of law, and there is proposed legislation that would treat carried interest as ordinary income. As a result of these tax increases, private equity professionals are keenly interested in methods and strategies for reducing their taxable exposure. One vehicle for doing so is implementation of a defined benefit plan.

This white paper will cover three primary topics as they relate to defined benefit plans: 1) What changes were made to the retirement plan laws that created the defined benefit plan opportunity? 2) How do defined benefit plans work and what are their principal features and benefits?, and 3) Why are defined benefit plans particularly powerful for private equity firms?

Legislative changes to defined benefit plans

In 2006, a sweeping piece of legislation was passed called the Pension Protection Act of 2006 (the “PPA”). One of the many changes the PPA made was to make implementation of defined benefit plans more advantageous for business owners. It did so principally by increasing the maximum deductible contributions to defined benefit plans and to various combinations of defined benefit and 401(k) plans.

Prior to the PPA, the max a partner could put into all retirement plans was limited to the greater of 1) their required annual contribution to the defined benefit plan, or 2) 25% of eligible participants’ compensation. This meant that if an employer had a defined benefit plan and a 401(k) plan, it was highly unlikely that they could contribute to both. Thus the advantage of combining the two plans was severely diminished.

Post PPA, a private equity firm can now combine a 401(k) plan with a defined benefit plan and be assured that they can maximize the contributions available in both plans without worrying that the contributions to one plan will negate the contributions to the other.

This benefits partners more than it benefits other employees because partners earn substantially higher wages than do their employees and were thus previously deprived of a greater percentage of their potential contributions. The net result is a de facto increase in the amount that partners can contribute annually which is substantially higher than that which can be contributed by a non-partner.

In addition to increasing participants’ annual contributions, the PPA clarified and directly addressed a number of outstanding questions which had plagued early defined benefit plan adopters. Actuaries, CPA’s and plan administrators struggled with policy gaps that left unanswered questions in the areas of age discrimination, lump sum payouts calculations, and variable rates of return as they related to defined benefit plans.

Without an exhaustive explanation of the above concepts, suffice it to say that the PPA clarified a number of questions and issues and eliminated many of the accidental pitfalls that inadvertently left early defined benefit plan adopters on the wrong end of the IRS. This clarification gave many companies considering implementing a defined benefit plan a much higher comfort level in moving forward.

How do defined benefit plans work?

Defined benefit plans, at their core, are essentially self-funded pension plans. Thus, it is helpful to first understand the difference between the traditional pension plans with which most of us are familiar, and those contemplated by the PPA.

In a traditional pension plan, employees worked for a certain period of time (usually 10-20 years), retired, got a gold watch with the company logo on the face, and then the company paid them a percentage of their salary for the rest of their lives. The monies used to fund these obligations came from the companies themselves and were a general corporate obligation.

In a modern defined benefit plan, rather than the employer being solely responsible for providing retirement benefits to participants, employees fund their own pension by making pre-tax contributions from their salaries, much as they would for a 401(k). The plan participants contribute a certain amount each year, and then when they are ready to retire, they stop contributing and begin withdrawing the accumulated monies, either as a lump sum or in meted doses throughout the remainder of their lives, whichever they prefer.

With that key difference in mind, we turn to an examination of the features and benefits of a modern defined benefit plan.

First and foremost, the main reason why private equity firms should consider a defined benefit plan is the substantial increase in pre-tax contributions. Unlike in a 401(k) plan which has fixed annual maximum contribution limits regardless of age ($16.5K or $22K if over 50), the amount a defined benefit plan participant can contribute increases exponentially with age.

This is because a defined benefit plan assumes a participant has a certain number of years, the time between when they enter the plan and when they retire, to save the overall plan maximum which today stands at $2.6 million. The older the partner, the less time they have before projected retirement, the less time they have to accumulate the maximum $2.6mm, and therefore the greater their annual contribution limits. The result is an annual maximum contribution that far exceeds what is available under a traditional 401(k) plan.

By way of example, a partner in his or her early 50’s could contribute as much as $200K by layering in a defined benefit plan to complement the firm’s existing 401(k) plan. A partner in their 40’s would be able to contribute less, and a partner in their 60’s more. Plans which maximize contributions across all plans and ages would result in a partner in their 60’s able to contribute upwards of $285K, annually.

Keep in mind that these numbers are maximums, and younger partners who had greater cash flow needs (perhaps due to new mortgages, tuition, etc…) could contribute less if they so desired, whereas older partners with lower overall expenses and fixed costs could contribute anything up to the maximum.

With these increased limits in mind, there are a number of critical aspects of defined benefit plans that must be carefully considered, as they are in some cases, substantially different than what most individuals are used to with 401(k) plans.

Unlike 401(k) plans, defined benefit plans are not “self-directed”, meaning that individuals contributing to the defined benefit plans do not have direct control over the manner in which their contributions are invested. Rather all contributions from all participants are deposited into a single pension account which is managed according to an investment policy statement.

This investment policy statement generally mandates a very conservative investment approach with a consistent and stable return profile. This is because a participant’s maximum annual defined benefit plan contributions are calculated by dividing the overall $2.6mm plan maximum by the number of years before the participant retires plus estimated returns on invested assets during that timeframe.

Thus, if a participant’s contributions appreciate more than the assumed rate of return for an extended number of years, eventually the participant will be required to contribute less to the defined benefit plan (“overfunding”), resulting in lower deductible contributions. The reverse is also true if the participant’s contributions underperform the assumed rate of return, in which case the participant will be required to increase contributions to make up for the shortfall (“underfunding”).

The concept of over or underfunding makes the investment policy statement, and the investments that flow from it, critically important to ensuring that annual required contributions are predictable and level. Level contributions are important because, unlike in a 401(k) plan, contributions to a defined benefit plan are mandatory for as long as the participant remains in the plan. Thus it is crucial to ensure that participants are able to consistently and comfortably make whatever annual contributions they elect to make.

That said, participants who find they need excess capital in a given year are not completely without relief. In cases where cash flow becomes an issue, participants can utilize their 401(k) plan as a pressure relief valve and pull back contributions to that plan. Although this is not ideal, it does provide some modicum of flexibility in the event of a significant shortfall.

In order to avail themselves of substantially higher annual pre-tax contributions into a defined benefit plan, partners must make some form of mandatory contribution to non-partner employees who earn less than $105K per year. However, most private equity firms are already making generous contributions to the employees’ 401(k) or profit sharing accounts, either in the form of matches or safe harbor contributions, in order to maximize the amount that the partners can contribute to their own accounts.

The good news is, these employee 401(k) contributions can be used to offset contributions required by the defined benefit plan. In many cases, private equity firm partners can recognize all of the additional contribution benefits of a defined benefit plan without increasing the contributions already being made to their employees.

Finally, as with any good investment, it is important to understand the defined benefit plan exit strategy. Although the name “defined benefit plan” suggests that contributions be aggregated and then progressively drawn down over time, the IRS allows defined benefit plan participants to take a lump sum distribution when they separate service from the firm. That lump sum distribution is equal to the total of all the participant’s contributions, plus any appreciation attributable to their pro rata portion of the portfolio.

Once the partner separates service from the private equity firm, they can then take this lump sum distribution and roll it directly into their IRA, where they will have complete autonomy over how the funds are invested and ultimately distributed. Because the IRS allows for a tax deduction for any contributions made into a defined benefit plan, the net effect is a federal subsidization of individual partners’ IRA’s.

Why are defined benefit plans powerful for private equity firms?

Defined benefit plans are not appropriate for all organizations. However, they are a particularly good fit for private equity firms for a variety of reasons. First and foremost, defined benefit plans are only appropriate for individuals that have high earned income. This prerequisite is met for private equity general partners because their management fees alone generally mean they are earning in the high six to seven figures per year.

The high W2 income is critical for several reasons. From a cash flow standpoint, participants in a defined benefit plan need to have enough disposable income to make the annual pre-tax contributions without inhibiting lifestyle. A defined benefit plan, and the required annual contributions that accompany it, will not work well for an individual that has unpredictable or inadequate cash flow to meet capital expenditures and normal costs of living.

However, many private equity professionals find themselves with excess investible income. The question then becomes is it more advantageous to pay taxes up front, and then invest the net remainder in a taxable account, or is it better to invest pre-tax money and grow it in a tax-deferred environment?

For most private equity partners, the numbers clearly favor investing money pre-tax and growing it in a tax-deferred environment. Aside from the obvious advantages to compounded tax-deferred growth, general partners have very high earned incomes. This means they are almost always in the highest tax brackets at both the federal and state levels and the government takes a very significant piece of the assets before they can be invested in a taxable account.

Moreover, it seems clear given the current administration and Congressional composition that taxes are more likely to increase than decrease going forward. These tax increases will directly affect private equity professionals in three ways: 1) their ordinary income tax rate will increase as income taxes are raised for the highest tax brackets, 2) favorable long term capital gains rates are likely to be increased making investments in taxable accounts far less advantageous, and 3) taxation of carried interest is likely to increase from the current long term capital gains rate to the ordinary income rate.

The combination of these tax increases, which will materially adversely affect private equity professionals, make defined benefit plans and other pre-tax retirement savings vehicles very powerful tools that should be considered as a method of offsetting the new tax regimes.

However, defined benefit plans are powerful for private equity firms for more reasons than just the compensation structures and tax rates of the general partners. The actual employment structure of most private equity firms work well within the defined benefit plan architecture. This is predominantly due to the fact that private equity firm org charts tend to minimize the mandatory contributions that must be paid to non-partners, while at the same time maximizing the partner contributions.

First, private equity firms generally have far fewer employees than do traditional larger companies. Since most third party administrators calculate their annual administration fees based upon a base fee plus an additional per employee fee, the fewer the employees, the lower the overall cost to administer the plan.

An advantageous by-product of having fewer employees, is that required contributions to non-partners are limited in scope simply because the ratio of partners to non-partners is typically fairly tight. Private equity firms are comprised mostly of investment professionals and the staff that supports them, without a large degree of middle management that might otherwise qualify for mandatory contributions if a defined benefit plan were implemented.

In addition, many non-partners make more than $105K per year and are thus considered “highly compensated.” Highly compensated employees can, at the option of the private equity firm, be excluded from mandatory contribution calculations. If all non-partners qualified as highly-compensated, it’s entirely possible the private equity firm could implement a defined benefit plan, maximize the contributions for the partners, and not be required to make any contributions for non-partners.

That said, if there were some non-partners that did not qualify as highly-compensated, often the age of these employees is advantageous for private equity firms. As mentioned above, defined benefit plan contributions are age-based. However, certain anti-discrimination testing must be met in order to ensure the plan is not unfairly favoring the older partners.

Because of the way this testing is designed, the greater the age difference between the partners and the employees, the greater the amount the partners will be able to contribute each year. For many private equity firms, the partners are significantly older than the staff supporting them, and as a result, they are able to contribute more to the defined benefit plan.

The turnover rate for both partners and employees is also advantageous for private equity firms considering a defined benefit plan. Partners tend to stay at a single private equity firm for extended periods of time, which means that the plan is comparatively easier and more cost effective to administer since the primary participants and major contributors remain relatively constant.

Non-partner employees on the other hand, have a comparatively high turnover ratio. However, the defined benefit plan allows for delayed eligibility for up to one year, and a vesting schedule that can be stretched to over seven years. This lessens the impact departing or transient employees can have on the plan and mitigates their ability to receive mandatory contributions, keeping the costs associated with the plan lower.

In addition, the existing private equity firm retirement plan structures, typically a 401(k) profit sharing plan, often make implementation of a defined benefit plan cost effective from a mandatory contribution standpoint. In most cases, private equity firms are already making substantial contributions to their non-partner employees in order to maximize the partner contributions to their own retirement accounts. These contributions are often equal to or in excess of the contributions required to add a defined benefit plan to the existing retirement plan. This often means that partners can dramatically increase their pre-tax contributions, but with little or no increase in mandatory contributions to non-partner employees.

As is the case with existing retirement plans such as 401(k)’s, employer contributions to participants’ defined benefit accounts are dollar-for-dollar tax deductible to the private equity firm. This is particularly powerful for private equity firms because the bulk of the defined benefit plan contributions can be structured as employer contributions, which means the income tax deduction to the firm tracks closely to the total dollar value of the yearly defined benefit contributions. Since the partners are in fact the owners of the firm itself, this deduction flows ultimately to them based on their pro rata ownership interest.

Finally, a defined benefit plan can be particularly advantageous to private equity partners because of the way defined benefit assets are invested relative to the risk assets present in a typical private equity professional’s portfolio. As was mentioned above, assets invested in a defined benefit plan are usually allocated to relatively conservative vehicles that deliver consistent and stable returns. These instruments tend to be various forms of fixed income assets that have a high degree of liquidity.

The defined benefit plan investment thesis is generally complementary for private equity professionals because, in most cases, a significant portion of their net worth is tied up in their private equity funds. While these investments have the potential for outsized returns, they also represent a comparatively riskier and less liquid asset class. Thus from an asset allocation standpoint, the fixed income-focused defined benefit portfolio often provides beneficial balance to the partners’ private equity positions.

Case Study

With a firm understanding of the changes made to the retirement plan laws which gave rise to the defined benefit plan opportunity, the features and benefits of a defined benefit plan, and why it is particularly powerful for private equity firms, we turn now to a real world example.

Our most recent defined benefit plan client had an existing 401(k) plan to which the six partners were contributing $79K per year and the three non-partners $30K, which meant that partners were receiving 73% of all contributions.

By implementing a defined benefit plan and adjusting their existing 401(k) plan, total partner contributions were increased to $717K and non-partners to $55K, which meant that partners were now receiving 93% of all contributions and those contributions were substantially greater dollar values.

For an annual administration cost of approximately $5K per year, this client was able to increase annual pre-tax retirement contributions by more than 10x and ensure that the vast majority of those contributions went to the partners.

In addition, the client received a dollar for dollar tax deduction for the contributions in the amount of $723K, a deduction which the client can take every year.

Conclusion

Defined benefit plans can be a very powerful addition to a private equity firm’s retirement plan architecture: they dramatically increase partners’ pre-tax retirement plan contributions while keeping non-partner costs comparatively low, lower partners’ taxable income, provide a dollar-for-dollar income tax deduction to the firm, and provide balance to otherwise aggressive asset allocations. 

Defined benefit plans are not for every private equity firm. However, for those partners who want to superfund their retirement savings in a very short period of time, and have the free cash flow to do so, they are a very attractive option, particularly in light of the disadvantageous tax regime in which they find themselves.

At a minimum, a defined benefit plan should be carefully explored and evaluated based on the specific census data associated with the individual firm to determine if it is something which would be beneficial for the partners to pursue.

About the Author

Jonathan Porter, Esq.

JONATHAN PORTER, ESQ
Director, Three Bridge Wealth Advisors

Mr. Porter is one of four financial advisors at Three Bridge Wealth Advisors LLC, an independent boutique wealth management firm based in the San Francisco Bay Area that works exclusively with private equity professionals and the entrepreneurs of the companies they finance.  Three Bridge utilizes a process-driven, value-based approach to provide its clients with personalized investment consulting, advanced planning, and expert relationship management.

Jon brings to the team a unique blend of corporate and legal experience along with his keen intellect and high energy. He works directly with both entrepreneurs and venture capital and private equity firm partners to help them plan in advance for liquidity events and the resulting wealth creation.

In particular, Jon assists owners of private equity grow their positions, and ultimately transfer them to designated beneficiaries, in the most tax-efficient manner possible. This is accomplished through a variety of planning strategies involving trusts, limited partnerships, and private charitable organizations such as donor advised funds and family foundations.

Jon also assists entrepreneurs and venture capital firms in establishing corporate retirement plans such as 401(k), profit sharing, and defined benefit plans and helps Three Bridge clients optimize these plans to minimize taxes and maximize retirement savings for both owners and employees.

Once Three Bridge clients realize liquidity from their private company investments, Jon works with them to hedge and monetize the concentrated stock positions, and eventually diversify them into an investment portfolio that is aligned with individual cash flow needs, values, goals, and objectives. As these assets are managed and invested, Jon works in tandem with clients' estate planning attorneys and CPA's to ensure that assets are protected and transferred in the most tax efficient manner possible.

Prior to helping found Three Bridge, Jon was a Financial Advisor in the Venture Group at Morgan Stanley Smith Barney's Menlo Park office, where he worked with his fellow partners providing similar wealth management services to select successful individuals and families in the San Francisco Bay Area. Before that, he spent five years heading the global licensing group at Apple, Inc. where he was responsible for developing and executing Apple's third party licensing strategies worldwide. Prior to Apple, Jon was the Director of Business Development for Lambda Optics, and worked in the corporate finance group for international law firm Morrison and Foerster, LLP.

Jon holds a Juris Doctor, Magna Cum Laude, from the Santa Clara University School of Law where he focused on high-tech, intellectual property, estate planning, corporate finance, business and tax law. He also holds a BA, with honors, in Political Science and English from the University of Washington. He is a member of the California State Bar Association and holds Series 7, 66, and multiple state insurance licenses.

Jon is actively involved with both the University of Washington and the Santa Clara University School of Law, frequently guest lecturing on topics relevant to his role as a private wealth advisor. Jon is an avid outdoor sporting enthusiast and enjoys golfing, SCUBA diving, surfing, snowboarding, wakeboarding, mountain biking, and of course throwing the Frisbee for his Jack Russell Terrier, Bella.