A floor offset plan is a little-known retirement structure. It is one of the market’s most advanced structures. It involves combining two plan designs to work together to maximize owner contributions.
In order to have a floor offset arrangement, both a defined benefit and a defined contribution plan must be in place. The term floor offset describes the relationship between the defined benefit and the defined contribution plan.
In this post, we will take a look at how these plans work and look at a specific example. Let’s jump in!
What are Floor-Offset Plans?
A floor offset plan combines two separate retirement plans. But these plans are “tied together” to provide a unique structure.
One of the retirement plans is a defined benefit plan, and the other is a profit-sharing plan. The business owner receives the maximum benefit under the defined benefit plan, while the profit sharing plan provides the minimum allowable amount to the employees.
The actuary will cross-test both plans to ensure the plans pass all IRS non-discrimination testing and compliance requirements.
How the Benefit in the Defined Benefit Plan is Calculated
An equivalent normal retirement benefit that could be provided by the account balance in the defined contribution plan is calculated using the definition of actuarial equivalence in the defined benefit plan.
This requires a projection of the account to the normal retirement date, and the method of projection must be specified in the defined benefit plan document.
Floor-offset plans are subject to a uniformity requirement. A level percentage of compensation must be used to offset the defined benefit plan benefits for all participants, even if the employer provided benefit in the defined contribution plan is not allocated uniformly.
If the equivalent benefit determined from the defined contribution plan exceeds the accrued normal retirement benefit from the defined benefit plan, the participant will receive benefits exclusively from the defined contribution plan.
In other words, the participant’s net benefit in the defined benefit plan would be $0. Even when the change in a participant’s net benefit over the course of a plan year is zero or negative, that participant is still considered to be benefitting under 401(a)(26).
If the equivalent benefit from the defined contribution plan does not exceed the accrued benefit from the defined benefit plan, then the total benefit that the participant will receive from both plans will be equivalent to the full pension benefit under the defined benefit plan’s formula.
The participant will receive the account balance from the defined contribution plan, plus the net accrued benefit (defined benefit accrued benefit less the defined contribution equivalent benefit) from the defined benefit plan. Elective deferrals under a 401(k) plan cannot be used to offset a participant’s benefit under a defined benefit plan.
The defined benefit plan can use either a flat benefit or unit benefit formula. It can also use permitted disparity for the tax return.
Floor-Offset Plan Example
Let’s look at an example. Assume you have a small, profitable business with five employees. You are looking for retirement contributions over $100,000, but you want to minimize employee allocations.
You hear about a defined benefit and plan and wonder if that is a good fit. But if you only have a defined benefit plan, you could make too large of an employee contribution. This is where a floor offset plan can help.
The IRS allows you to separate groups in a defined benefit plan. In addition, each group can have a different allocation formula. This can allocate different amounts to employees based on job description, location, etc. As the business owner, you are a part of one group, while the non-owner employees are a part of another group.
The allocation formula is usually a specific percent of compensation earned in retirement. As the business owner, you can receive a contribution of 100% of your annual compensation. However, the contribution is subject to a cap of $250,000 (adjusted annually) each year after retirement.
You can structure the plan so employees might receive 5% of their wage as retirement benefits. But there is one additional component.
The profit-sharing plan is designed to support the defined benefit plan. All eligible employees are allocated a minimum of 5% of compensation in the profit-sharing plan. These allocations are provided to “offset” the employee allocations in the defined benefit plan.
In most instances, the full employee benefit under the defined benefit plan are offset, and the employees will only receive the 5% profit-sharing contribution.
Floor Offset At Retirement
- Defined benefit plan participant’s gross accrued benefit before offset: $300/month
- Defined contribution plan participant’s equivalent benefit: $200/month
- Defined benefit floor offset participant’s net benefit = $300 – $200 = $100/month
The overall result is that the participant is entitled to the defined contribution account balance and a floor offset benefit of $100/month from the defined benefit plan.
Note that the participant does not receive the equivalent benefit of $200/month instead of the defined contribution account balance. This $200/month is just used in the determination of the floor offset amount from the defined benefit plan.
Here is another example:
- Defined benefit plan participant’s gross accrued benefit before offset: $200/month
- Defined contribution plan participant’s equivalent benefit: $300/month
- Defined benefit floor offset participant’s net benefit = zero
The overall result is that the participant is entitled to only the defined contribution account balance.
Floor Offset Concerns
If the employer’s intent is to phase out a defined benefit plan in favor of a new defined contribution plan, a floor offset arrangement can maintain the expected defined benefit for participants near retirement while younger workers will gradually build up defined contribution balances large enough to allow the eventual termination of the defined benefit plan with no decrease in benefit levels from those offered by the traditional defined benefit plan.
Participants seem to better understand and appreciate a defined contribution plan.
Younger employees can see a definite build-up of plan assets in the defined contribution plan.
The defined contribution plan could be a profit sharing plan, thus providing considerable contribution flexibility. Employees who continue in service until retirement age are assured of a minimum retirement income equal to that provided by the defined benefit plan. There is no such assurance when the only plan is a defined contribution plan.
The following table compares a floor offset design to a traditional defined benefit plan:
|Very Complex Design
|Higher Employee Contributions
|Great With Younger Employees
|Higher Admin Costs
|Maximum Owner Allocation
|Lower Overall Owner Allocation
The floor offset is not a direct subtraction of benefits provided. The actuary can offset the benefits using an assumed retirement age of 62 or 65 at retirement.
If there are employees who are older than the owner, benefits might not be able to be offset completely. The more senior employees will receive the profit-sharing allocation, and any remaining benefits not offset are included in the defined benefit plan.
A floor offset defined benefit plan is probably the only plan structure that allows you to make a significant contribution for the owner while keeping employee allocations in the 5–7.5% range.
A floor offset plan can work great in the right situation. Make sure you discuss with your administrator to see if a plan makes sense for you.
The effects of compound interest mean younger employees achieve higher retirement income levels in a defined contribution plan. The defined benefit plan allows employees hired later in life to accumulate higher levels of retirement benefits far more rapidly than would be allowed in a defined contribution plan. As a result, both younger and older employees can derive higher benefits than from a single defined benefit or defined contribution plan.