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Retirement: What’s your plan?

Issue: October 2007

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Orthopedic surgeons in larger groups often must decide the cost/benefit differences between group 401(k) plans vs. individual plans. Will the extra costs of covering the employees outweigh the value of the contributions to the orthopedist’s plan?

If a plan is accepted by all partners, modern portfolio theory simply states that stocks could be selected in such a way that the whole is less risky than each stock individually (diversification). This risk reduction often determines the return. Models on this theme will continue to evolve.

If a plan is not accepted by the whole group, then nontraditional, alternative plans are available. There is also a group of nonqualified plans worth considering that are often off the orthopedist’s radar.

Lastly, plan compliance has become increasingly important due to such debacles as the Enron case. Failure to follow the plan’s mission may lead to lawsuits. Although many mutual funds or secondary companies provide and monitor these plans, the orthopedist remains ultimately responsible for plan compliance.

For this month’s Orthopedics Today Round Table discussion, we have assembled four experts who can help us understand these various situations.

Douglas E. Garland, MD
Orthopedics Today
Editorial Board Member

Douglas E. Garland, MD: What type of retirement plan would you suggest for a physician who wishes to retire within 5 years and wants to defer maximum income during that period into a retirement plan, but he or she has a new associate who has been designated as the successor to the practice and has different retirement goals?

Richard L. Green, CPC, APA: A defined benefit plan would be an ideal solution for this situation. These plans offer a rapid accumulation of retirement assets over a relatively short period and are not limited in terms of contributions, but rather have maximum benefits that can be provided at a specific retirement age.

For example, a 57 year old planning to retire at age 62 years could accumulate a retirement fund of just over $1,088,000 over that 5-year period. This would require annual contributions of $184,800. Assuming the practice had been profitable in prior years, the physician could actually convert his or her entire income to plan contributions. In other words, in many situations it is not necessary to pay current taxable compensation in order to fund a defined benefit plan.

Practices with partners at different ages will benefit from adopting a 401(k) profit sharing plan in conjunction with the defined benefit plan. Minimal benefits must be provided to any employees in the defined benefit plan to meet minimum participation requirements, but the profit sharing plan would provide most of the required funding for employees, and would allow younger partners to vary contribution from year to year. The elder physician could also participate in the second plan, both through 401(k) salary deferrals as well as profit sharing allocations.

If the successor is purchasing the practice over time, he or she can effectively do so with pretax dollars by indirectly funding the retiring partner’s pension contribution. This has the advantage of transitioning the practice over time without generating additional current taxable income to the owner. At retirement, the defined benefit plan can be terminated, and the assets of the retired partner can be rolled to an Individual Retirement Account (IRA). Proceeds are taxed when withdrawn, with no required distribution until age 70.5.

Many retirement planning options exist for practices with varying contribution or benefit levels for each employee that provide maximum retirement accumulations to the owner, while employee contributions are limited to the required minimum. Each practice is unique, and we encourage anyone considering establishing a retirement program to consult with a qualified advisor to investigate the best plan for their situation.

Garland: Many practitioners worry that the burden and costs of administrating a qualified plan will take time away from their practice. What are the costs of plan administration compared to other arrangements?

Green: Retirement plans operate under a broad and complicated set of rules which make administering them difficult and time consuming.

Some arrangements have been streamlined to such an extent that a business owner could operate the plan without an administrator. For single-participant plans that are satisfied with the profit sharing maximum contribution, a Simplified Employee Pension (SEP) plan would be the right choice. These plans do not have any governmental filing requirements and contribution levels can vary annually. The trade off for the simplicity is a lack of flexibility regarding eligibility and allocation — so they may not be desirable for nonowner employees.

For owners who have employees and desire a low level plan with a 401(k) type feature, a Savings Incentive Match Plan for Employees (SIMPLE) plan is available. These plans offer a salary deferral option, with lower limits than available under a 401(k) plan. Employers must contribute to employees through either across-the-board-contributions or a match. Like SEPs, SIMPLE plans have no government filing requirements — and deposits go into individual IRAs. Because of the contribution requirement affiliated with the SIMPLE arrangements, employers often switch to 401(k) plans later to take advantage of the higher contribution limits.

For more complicated arrangements, the duties and responsibilities of the Plan Administrator and Trustee increase dramatically. These include:

• maintenance of the plan document to legal compliance;
• determination of plan eligibility;
• preparation and distribution of the Summary Plan Description;
• reconciliation of trust investment activity;
• calculation of required and available contribution;
• allocation of trust investment earnings;
• determination of vesting; and
• preparation of termination election forms to former employees, annual participation reports and required government filings.

This is not an all-inclusive list of administrative tasks, and each task requires time and attention to detail to be performed properly. The risks of not operating a plan properly: potential disqualification and loss of deduction and tax exempt status.

Garland: Many physicians are concerned over liability issues, both personally and with respect to the operation of a qualified plan. What are the risks in sponsoring a plan, and how can they be minimized?

Green: Properly administered, potential liability incurred through plan sponsorship can be limited, and personal assets held under an Employee Retirement Income Security Act (ERISA) qualified plan can be sheltered from all creditors.

A business owner who decides to establish a qualified retirement program will likely become a fiduciary with respect to the plan. Fiduciaries are individuals or organizations that have some discretionary control over plan assets or plan administration, and they can be held personally liable for any breaches of their responsibilities to properly discharge their duties under the plan. Plan fiduciaries can take several steps to limit their liability.

By engaging a third-party administrator to handle the duties of plan administration, fiduciaries can receive qualified assistance to ensure that the plan is operated according to its terms. With respect to plan assets, a plan sponsor can name an outside trustee to manage the trust investments. While this step will eliminate any fiduciary liability, it can be costly for a smaller plan, and plan sponsors often wish to retain some control over the investment of retirement plan assets.

A plan sponsor who wishes to retain control of investments but limit liability can create self-directed plan accounts under guidelines published by the Labor Department. Known as 404(c) plans, these arrangements must meet specific standards for disclosure and diversification. The guidelines seek an arrangement in which a plan participant can make an informed and appropriate choice as to the investment of their IRA. Properly established, a plan fiduciary will not be liable for the investment decisions of individual participants, while controlling the investment of his or her account. The guidelines are complex, however, and it can be difficult to completely eliminate fiduciary liability. Also, because 404(c) plans pertain to individual account arrangements, the guidelines are not applicable to defined benefit plans.

Assets held in a qualified retirement plan receive special creditor protection not available under other arrangements. Retirement plan accounts will not be considered personal assets attachable by creditors as long as the plan is an “ERISA-qualified plan.” This generally means a plan that covers at least one nonowner employee. While bankruptcy creditor protection was recently extended to single- participant retirement plans and IRAs, an individual must declare bankruptcy in order to take advantage of this protection. For practicing physicians, the only sure protection of personal assets can be obtained through a qualified plan account. For this reason, many physicians who have compiled significant retirement assets through previous retirement plans roll their IRAs into their current ERISA qualified plan.

Garland: I have some employees who have been with me for a long time and who I value in my practice, but there are others who probably won’t stay. I am concerned about the high cost of funding for eligible staff. What options are available for covering employees?

James R. Howe, CPC: All retirement plans must pass a variety of nondiscrimination tests each year. The most important test is the Minimum Coverage Test, which requires that tax-qualified plans cover eligible employees without discrimination. Retirement plans are permitted to exclude employees who have not been with a practice for at least 1 year and those who are under age 21. But after meeting those requirements, all other employees must be considered in the testing, if employed more half–time. A well-designed plan can still maximize contributions for the physician or physicians, but there will probably be some level of minimum cost required to cover eligible employees. All contributions are tax deductible, so usually this cost compares very favorably with taking the total plan contribution as additional taxable compensation.

We think each plan sponsor should determine how much they are willing to fund for their staff, either dollars or a percentage amount. The plan design can then optimize benefits for the owners or key staff based on this acceptable level of contributions. For instance, if the physician is comfortable funding 3% or 5% of compensation, then the plan will be designed around that figure and the demographic of the eligible employees. Designs may include some form of age leverage in the allocation formula or a combination of the traditional 401(k) plan with employer contributions added on top of the 401(k) contributions. There are plans that can increase contributions for practice owners, but the key consideration is that all staff who meet the minimum service and age requirements must be considered in the plan design.

The cost of covering eligible staff should be viewed as an alternative tax to what would have been paid if the plan was not funded. In California, the combined state and federal tax savings can approach 45% of the total contribution. Generally, setting aside before-tax retirement savings to grow on a tax deferred basis is a much more efficient way to accumulate savings, even if some benefits are funded for the staff.

Garland: I have sponsored several retirement plans over the years with my practice, but now I need to get serious about setting aside retirement funds. How much can I fund each year, and what is the best plan to adopt?

Howe: Many professional practices have sponsored multiple and varied plans over the years. The Internal Revenue Code has been amended from time to time to change limitations on annual contributions, and as practices mature the best choice of plan also changes. The type of plan and the annual contributions have to be compatible with the physician’s objectives for setting aside savings. The answer varies case by case depending on how much of the practice income can be diverted into a retirement plan and in some cases on the costs to fund eligible staff.

Having said that, the types of plan choices fall into two basic categories, defined benefit plans and defined contribution plans. Each type has annual limitations on contributions.

Defined benefit (DB) plans are coming back into favor because they can permit significant annual contributions. We have seen many DB plans in recent years with contributions above $100,000 for the physician, but those are usually adopted when the physician is within 10 years of retirement. DB plans also require annual contributions, and must cover a minimum percentage of participants each year. If a practice has more than one owner, equalizing contributions can be difficult. But these plans certainly permit the largest annual savings.

Defined contribution (DC) plans have an annual dollar limit on contributions for each participant — $45,000 in 2007. The favorable aspect of DC plans: Contributions can be fully discretionary, and in some cases can be funded for only those participants who also participate in funding through a 401(k) plan. The 401(k) contributions are part of the DC annual limit but if the participant is at least age 50, an additional $5,000 of catch-up contribution is permitted. These plans can be designed with a variety of matching formulas or as part of a cross-tested or tiered allocation plan that will allow very specific amounts to be funded for participants.

There are many options for designing combination defined benefit and defined contribution plans for a single practice, and they depend on the ages and compensations of the eligible employees. There is no single right answer that would apply to everyone, but the value a tax qualified retirement plan does apply to anyone who wishes to maximize their retirement savings.

Garland: I’ve read a lot about the Pension Protection Act (PPA) that was passed last summer. What changes are likely to happen to my retirement plan because of PPA?

Howe: Some provisions will impact all plans, others will depend on the type of plan each practice sponsors. Several take effect in 2007.

Most retirement plans for professional practices are top heavy, meaning 60% or more of the accrued benefits are for the benefit of the owners. PPA now requires that for all contributions deposited after 2006, the minimum vesting schedule must be no longer than the traditional 6-year top heavy schedule, rather than the 7-year schedule previously permitted.

Another PPA provision that could impact how a retired professional plans for their benefit distribution deals with who may roll over a benefit into an IRA. Before 2007, only participants, former participants, and their spouses could do so. Now any designated beneficiary will be permitted to take the full benefit from an employer-sponsored plan and roll it directly into an IRA. For professionals who may have left their benefits in a plan for the creditor provision, this greatly improves distribution planning in the event a spouse predeceases the professional before the benefit can be distributed.

Another very important provision deals with anyone who sponsors a 401(k) plan. Most of these plans permit participants to direct their own investments, and in that case the physician who is probably also the plan trustee, is trying to be protected from fiduciary liability for investment performance. Most of these plans are invested through some form of bundled investment strategy, but the default account is usually a money market fund. Under PPA, the default account, the place where balances are held until the participant provides an investment instruction, must now be some form of Qualified Default Investment Account (QDIA) that is a balanced or life cycle type fund. If the default isn’t properly established in accordance with QDIA requirements, the plan trustee will not be relieved of fiduciary liability for participants’ investments. It is extremely important that anyone in a 401(k) plan understand this rule and take steps to be certain the default investment fund meets these requirements.

Another provision that will probably interest most professionals involves limitations on contributions. Most sponsors are interested in maximizing their funding, and many new defined benefit plans permit large contributions. PPA has clarified some of the rules that affect cash balance plans, and they likely will increase in popularity among practices that want a plan with specified contribution amounts for eligible staff who may vary in ages. These cash balance plans can help take some confusion out of how more traditional defined benefit plan contributions are determined. In addition, another new rule permits a plan sponsor to fund a maximized defined benefit plan along with making contributions to a profit sharing plan of up to 6% of covered compensation. Participants over age 50 may also fund the catch-up contributions under a 401(k) provision, if that’s included in the plan. All of these changes will help increase the amount of annual contributions that may be funded on a tax deductible basis.

Garland: What is active risk management?

Michael McIntyre: Active risk management is the practice of reducing risk through dynamic investment transactions and through noncorrelational diversification. We think it is the future for investment risk management ie, reducing your investment exposure to risk.

Garland: What does that mean?

McIntyre: Years ago it was thought that lowering risk could be achieved primarily through asset allocation, like cutting a pie into different sectors, such as, 14% large cap, 15% short-term bonds, etc. Then the investor would periodically change and rebalance his/her allocations.

Garland: What is wrong with that?

McIntyre: Asset allocation is fine if you have a very long-term approach, let’s say 10 years or longer, and a strong stomach. The 2000-2001 market taught many people that, although they believe they are long-term investors, when the market drops 10%, 20%, or even 50%, as it did, they abandon this philosophy and want to get out. Unfortunately, an asset allocation model is at best a good rear-view mirror. Active risk management uses momentum as a defensive mechanism. A large index, such as the NASDAQ 100 or S&P 500, moves in rhythms. When the index’s rhythms are up, down, or neutral, a momentum investor can incorporate a portion of that rhythm into the portfolio. The most important part of momentum investing is, by far, missing the downturn. You wouldn’t drive a car without brakes, so why would you want to invest without them?

Garland: What do you mean?

McIntyre: If you lose 50%, math dictates that you have to make 100% to get back to even. A 100% short-term return on an entire portfolio is extremely unlikely, so it is much better to avoid the drop in the first place. A 50% drop could take many years to recover and could alter your lifestyle and plans, or it could even recur, as it did from 2000 to 2001.

Garland: Recently the equities markets have seen some troubling times. With many investors at or near retirement, is there anything that we can do to protect ourselves?

Robert J. O’Carroll: A 1-week decline is not itself a disaster, but it could be a foretaste of increasing market volatility. A minor correction isn’t always bad news, if investors know how to react to it. I am not talking about “buying on the dips,” I’m talking about asking a more fundamental questions: Am I optimizing my return with the lowest amount of risk? In other words, am I using defensive as well as offensive strategies?

Garland: By defensive, do you mean putting money in bonds?

O’Carroll: Great question! It assumes that stocks and bonds can’t go down at the same time. As we’ve seen, that is clearly not the case. What I’m talking about is having a true defensive component to your investments, a component that we call “Defensive Hedging.”

Garland: Why is defense so important?

O’Carroll: You can’t win the Super Bowl with just offense, and you can’t accumulate or protect wealth without defense either. In a rising market, most investment managers can make money. But, I can guarantee that over the next few years the markets will have a number of small corrections, and a handful of serious ones. What if you could avoid even a few of them? What if you could profit from a few? How would that affect your returns?

Defensive hedging is designed to mitigate downside risk while trying to gather some upside potential.

Garland: How does it work?

O’Carroll: Defensive hedging is deceptively simple: It is the tactical application of long, short or neutral strategies. These are the broadest investment styles of all. Using a model for analyzing and predicting market momentum, our manager may be short “bearish” (to profit on the market’s probable decline) or neutral (in cash) when he sees weakness. If he sees market strength, he positions the funds in a long (bullish) position. These programs may not be a panacea for all investors, but by potentially profiting on market corrections, they can potentially increase returns, and with lower risk than a typical MPT (Modern Portfolio Theory) allocation model.

For more information:

• Douglas E. Garland, MD, can be reached at 2760 Atlantic Ave., Long Beach, CA 90806-2755; 562-424-6666; e-mail: dougarland@msn.com.
• Richard L. Green, CPC, APA, can be reached at Windes & McClaughry Accountancy Corp., 111 W. Ocean Blvd, Suite 2200, Long Beach, CA 90802-4521; 562-435-1191; e-mail: RGreen@windes.com.
• James R. Howe, CPC, can also be reached at Windes & McClaughry Accountancy Corp.; e-mail: jhowe@windes.com.
• Michael McIntyre can be reached at Nexcore Financial Services, Inc., 10509 Vista Sorrento Parkway, Suite 300, San Diego, California 92121; 858-362-0390; e-mail: askmac@nexcorecapital.com.
• Robert J. O’Carroll can also be reached at Nexcore Financial Services; 858-658-9800, ext. 230; e-mail: rocarroll@nexcorecapital.com.