Once upon a time there were three little pigs. The first little pig
owned a company that built houses out of straw and sponsored a pension plan that invested in a diverse
portfolio of Blue Chip stocks. The second little pig owned a company that build houses out of sticks
and sponsored a pension plan that invested in a balanced portfolio of growth and income stocks.
The third little pig owned a company that built houses out of bricks
and sponsored a pension plan that invested exclusively in insurance contracts that provided a
guaranteed rate of return. In the 1990s, the first two little pigs bragged relentlessly about the
performance of the investments in their pension plans.
The third little pig remained silent. Suddenly, the big bad stock market
huffed and puffed and blew the plan investments of the first two little pigs down.
A few years later, the two little pigs retired penniless and moved into
the brick house generously given to them by the third little pig, who lived comfortably on
his retirement income happily ever after.
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 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 fourth 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 non insured 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?
The Employer wants to maximize his or her initial rate of contribution
The Employer is in good current financial condition
Substantial early funding is preferable for any reason
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
