2019 PEPRA compensation limits

The 2019 PEPRA compensation limits are $124,180 for Social Security members and $149,016 for non-Social Security members.

These limits are the maximum pay that a California public agency can recognize in a defined benefit plan for PEPRA members, i.e. those first hired by a public employer in 2013 or later.  “Classic” members hired from 1996 through 2012 are subject to the higher §401(a)(17) pay limit that applies to private sector employees.

Each year, the California Actuarial Advisory Panel (CAAP) publishes an “unofficial” calculation of the PEPRA compensation limit.  The 2019 limits are published on the State Controller’s Office website at Agenda Item #2 –PEPRA Pension Compensation Limit Letter for 2019.

CalPERS usually publishes the limits early in the calendar year.  The 2018 PERS notice is at https://www.calpers.ca.gov/page/employers/policies-and-procedures/circular-letters.  Search for letter #200-001-18.

We’ve confirmed all the PEPRA calculations in the CalPERS and CAAP letters.  The table below shows a complete set of the PEPRA compensation limits through 2019.

PEPRA Compensation Limit
Year Social Security Members Non Social Security Members
2013 $113,700 $136,440
2014 115,064 138,077
2015 117,020 140,424
2016 117,020 140,424
2017 118,775 142,530
2018 121,388 145,666
2019 124,180 149,016

For PEPRA members in the CalSTRS Defined Benefit (DB), Defined Benefit Supplement (DBS) and Cash Balance (CB) Benefit programs, the 2018-19 pay limit is $146,230.  Each year’s adjustments are based on February CPI figures and the limits apply to fiscal years.  Since CalSTRS members aren’t included in Social Security, only the non-Social Security figures are shown in the table below.  CalSTRS publishes a similar table at https://www.calstrs.com/post/final-compensation.

Fiscal Year PEPRA Compensation Limit  for CalSTRS Members
2013-14 $136,440
2014-15 137,941
2015-16 137,941
2016-17 139,320
2017-18 143,082
2018-19 146,230

 

What’s the Effect of 2019 IRS Retirement Plan Limits?

IRS Notice 2018-83 just announced the 2019 retirement plan benefit limits, and there are many changes since 2018. What does it all mean for employer-sponsored retirement plans? Here is a table of the primary benefit limits, followed by our analysis of the practical effects for both defined contribution (DC) and defined benefit (DB) plans.

Qualified Plan Limit 2017 2018 2019
415 maximum DC plan annual addition $54,000 $55,000 $56,000
Maximum 401(k) annual deferral $18,000 $18,500 $19,000
Maximum 50+ catch-up contribution $6,000 $6,000 $6,000
415 maximum DB “dollar” limit $215,000 $220,000 $225,000
Highly compensated employee (HCE) threshold $120,000 $120,000 $125,000
401(a)(17) compensation limit $270,000 $275,000 $280,000
Social Security Taxable Wage Base $127,200 $128,400 $132,900

 

 Changes affecting both DB and DC plans

  • Qualified compensation limit increases to $280,000. This is a similar increase to recent years, so highly-paid participants will now have more of their compensation “counted” towards qualified plan benefits and less towards non-qualified plans. This could also help plans’ nondiscrimination testing if the ratio of benefits to compensation decreases.
  • HCE compensation threshold increases to $125,000. It’s nice to have an increase after several years of a stagnant $120,000 limit. Employers may find that slightly fewer participants meet the new HCE compensation criteria, which could have two direct outcomes:
    • Plans may see marginally better nondiscrimination testing results (including ADP results) if there are fewer HCEs. It could potentially make a big difference for smaller plans that were very close to failing the tests.
    • Fewer HCEs means that there are fewer participants who must receive 401(k) deferral refunds if the plan fails the ADP test.

Note that there is a “lookback” procedure when determining HCE status. This means that the 2020 HCEs are determined based on whether their 2019 compensation is above the $125,000 threshold.

 

DC-specific increases and their significance

  • The annual DC 415 limit increases from $55,000 to $56,000 and the 401(k) deferral increases to $19,000. Savers will be glad to have more 401(k) deferral opportunity, albeit a modest $500 increase. Even though these deferrals count towards the total DC limit, employers can also increase their maximum profit sharing allocations. Individuals could potentially get up to $37,000 from employer matching and profit sharing contributions ($56K – $19K) if they maximize their DC plan deductions.
  • 401(k) “catch-up” limit remains at $6,000. Participants age 50 or older still get a $6,000 catch-up opportunity in the 401(k) plan, which means they can effectively get a maximum DC deduction of $62,000 ($56K + $6K).

 

DB-specific increases and their significance

  • DB 415 maximum benefit limit (the “dollar” limit) increases to $225,000. This is the third straight year we’ve seen an increase in the DB 415 limit after three years of static amounts. The effect is that individuals who have very large DB benefits (say, shareholders in a professional firm cash balance plan) could see a deduction increase if their benefits were previously constrained by the 415 dollar limit.

 

Social Security wage base and integrated plans

  • Social Security Taxable Wage Base increases to $132,900. This is a substantive $4,500 increase from the prior limit. A higher wage base can reduce the rate of pension accruals and DC allocations for highly-paid participants in integrated pension and profit sharing plans that provide higher rates above the wage base.

Professional Firm Retirement Plans and the New QBI Tax Deduction

Qualified retirement plans were a good deal before the December 2017 Tax Cuts and Jobs Act.  For many professional firms, they’re now better than ever.

Here’s the new part:  many owners of pass-through businesses like S corporations, LLCs and sole proprietors are eligible for a 20% deduction on Qualified Business Income (QBI), essentially non-W2 business income (profits).

For “specified service businesses”, i.e. most professional firms, the 20% deduction is limited in 2018 for owners with income of more than $315,000 (married) or $157,500 (single) [1].  It’s completely eliminated for owners with income of more than $415,000 (married) or $207,500 (single).

If your income is below the threshold, you’re eligible for the entire 20% deduction.  If your income is too high, retirement plan contributions can bring it down below the threshold.

The combined effect of the retirement plan and QBI deductions can be astonishing.

Let’s take the example of Rachel, a 50 year old married partner in a successful LLC.  Her share of the firm’s profits is $376,000.  If she maximizes her 401(k) deferral and the firm maximizes her profit sharing contribution (total of $61,000 with catchup), her income has dropped to $315,000.  She’s entitled to the $61,000 deduction and, in addition, she can now deduct the entire 20% of QBI.  The table below shows how it works:

 With 401(k)/ PS Contribution

 Without 401(k)/ PS Contribution

 Income before contribution [2]

 $  376,000

 $   376,000

 Retirement plan deduction

      (61,000)

              –  

 Income before QBI deduction

     315,000

      376,000

 QBI deduction
 Full deduction percentage

20%

20%

 Adjusted % (phase-out)

20.00%

7.80%

 Deduction amount

       63,000

        29,328

 Federal income tax (FIT) [3]

       43,299

        66,634

 FIT savings

 $    23,335

By contributing $61,000 to her own retirement account, Rachel has reduced her 2018 taxable income by $94,672 and her federal income taxes by $23,335.  And that doesn’t even include her savings in FICA or state & local income taxes.

What if Rachel’s firm is even more successful, so that her share of the profits is $526,000?  With the right demographics, it’s still possible to contribute enough to bring her income down to the $315,000 threshold.  To do that she’ll need a cash balance plan, which works especially well for professional firms.  Partners around age 50 can contribute up to $150,000 – in addition to the $61,000 401(k)/profit sharing contribution.  Older partners can contribute more than that: up to $280,000 cash balance at age 62 – for a total contribution of $341,000 (!) with 401(k) and profit sharing.

The next table shows this scenario for Rachel:

 With
Cash Balance and 401(k)/PS Contribution

 Without
Cash Balance and 401(k)/PS Contribution

 Income before contribution [2]

 $     526,000

 $      526,000

 Retirement plan deduction

       (211,000)

                 –  

 Income before QBI deduction

        315,000

         526,000

 QBI deduction
 Full deduction percentage

20%

20%

 Adjusted % (phase-out)

20.00%

0.00%

 Deduction amount

          63,000

                 –

 Federal income tax (FIT) [3]

         43,299

         127,079

 FIT savings

 $       83,780

This time, Rachel has reduced her 2018 taxable income by $274,000 and her federal income taxes by $83,780 by contributing $211,000 to her own retirement accounts.  And that still doesn’t include her savings in FICA or state & local income taxes.

Qualified retirement plans have always been a sweet deal for professional service firms.  And they just got a lot sweeter.

At this writing (October 2018), there are just a couple months left to set up a plan for 2018.  You’ll need to run some numbers, make the necessary plan design decisions and have a signed plan document in place by December 31.  Just let us know if you’d like to take a look.

 

[1] It’s also limited to 50% of W2 pay in many cases.  We’ve chosen a partnership-taxed LLC to simplify this example.

[2] Assuming the same non-owner retirement plan contributions in both columns.  In real life, non-owner contributions are an important plan design component – but we’ve simplified them here.

[3] Simplified calculation ignoring AMT and non-standard deductions.

2018 PEPRA compensation limits

The 2018 PEPRA compensation limits are $121,388 for Social Security members and $145,666 for non-Social Security members.

These limits are the maximum pay that a California public agency can recognize in a defined benefit plan for PEPRA members, i.e. those first hired by a public employer in 2013 or later.  “Classic” members hired from 1996 through 2012 are subject to the higher §401(a)(17) pay limit that applies to private sector employees.

Each year, the California Actuarial Advisory Panel (CAAP) publishes an “unofficial” calculation of the PEPRA compensation limit.  The 2018 limits are published on the State Controller’s Office website at Agenda Item #4 – Draft CAAP 2018 PEPRA Limit Letter November 21, 2017.

CalPERS usually publishes the limits in late February or early March.  The 2017 PERS notice is at https://www.calpers.ca.gov/docs/circular-letters/2017/200-010-17.pdf.  Update 1/16/2018: the 2018 PERS notice is at https://www.calpers.ca.gov/page/employers/policies-and-procedures/circular-letters.  Search for letter #200-001-18.

We’ve confirmed all of the PEPRA calculations in the CalPERS and CAAP letters.  Here is a complete set of the PEPRA compensation limits through 2018:

PEPRA Compensation Limit
Year Social Security Members Non Social Security Members
2013 113,700        136,440
2014 115,064        138,077
2015 117,020        140,424
2016 117,020        140,424
2017 118,775        142,530
2018 121,388        145,666

2017 Pension Lump Sums Are Looking More Affordable

How quickly things change! A month ago we were anticipating very expensive 2017 lump sum costs for defined benefit (DB) pension plans due to continually low interest rates. However, rates have been on a strong rebound since the election and now 2017 lump sums are looking much more affordable.

The IRS recently released the November 2016 417(e) interest rates which are used by many DB plans as the reference rates for lump sum payments. These three segment rates are 20 to 35 basis points higher than the October 2016 rates, though overall they are still lower than the November 2015 rates.

This post shares a brief update of the impact these rates could have on 2017 lump sum payout strategies.

Glass Half Full: 2017 Lump Sum Costs Are Going Up, But Less Than Expected

The table and chart below show the possible difference in lump sum values at sample ages assuming payment of a $1,000 deferred-to-65 monthly benefit. The calculations compare the November 2015 rate basis to the November 2016 basis.

Although the projected 2017 lump sum costs are still higher than 2016, the increases are only half of what we were expecting a month ago. It remains to be seen if rates continue their upward trend, but the reduction in anticipated lump sum cost increases may encourage more plan sponsors to embrace pension risk transfer (PRT) strategies like lump sum windows for terminated vested participants.

The November lump sum rates aren’t the end of the story for 2017 PRT opportunities either. If rates continue to increase, then plan sponsors will want to consider using a different reference period for the temporary lump sum window to reflect the higher rates. Even if rates don’t rise anymore, 2017 will likely be the last year to pay lump sums without reflecting new mortality assumptions in 2018.

2016 Pension Accounting Preview: a Positive Outlook

Many defined benefit (DB) plan sponsors are aware that interest rates dropped significantly in the first half of 2016 but staged a remarkable rise since the November election. Combined with relatively strong equity returns, 2016 year-end pension disclosures may not be as bad as expected 6 to 8 weeks ago.

Discount Rate Analysis

Using the November 2016 Citi Pension Liability Index (CPLI) and Citi Pension Discount Curve (CPDC) as proxies, pension accounting discount rates are down by about 20 basis year-to-date. Although they’re not quite up to 2015 year-end levels, the rebound (from almost 90 bps lower than last year) is welcome relief to pension plans.

In the chart below, we compare the CPDC at three different measurement dates (12/31/2014, 12/31/2015, and 11/30/2016). We also highlight the CPLI at each measurement date. The CPLI can be thought of as the average discount rate produced by the curve for an “average” pension plan.

nov-2016-citigroup-curve

Net Effect on Balance Sheet Liability

The other half of the pension funded status equation is the plan asset return. Like discount rates, it’s been a bumpy year but it appears to be ending in the right direction. Domestic stock indices are doing well and a balanced portfolio is likely at or above its expected return.

Depending on the starting funded status, the change in pension liabilities and assets can have a leveraging effect on the reported net balance sheet asset/liability.

Below is a simplified illustration for a plan that was 80% funded on 12/31/2015. We assume a 5% increase in pension liability during 2016 and then compare the funded status results under two asset scenarios: (1) Assets 5% higher than 12/31/2015 and (2) Assets 8% higher than 12/31/2015.

illustration-of-change-nov-16

In the first scenario, the plan’s funded percent remains constant at 80% even though the dollar amount of pension debt increases by about 5%. In the second scenario, the funded status actually improves slightly both on a percent and dollar basis.

Conclusions

So, what should plan sponsors be considering over the next month as we approach year-end? Here are a few ideas.

  • The 2016 Society of Actuaries mortality table updates will likely be recommended for use at year-end. Those tables should decrease pension liabilities slightly for most plans.
  • Don’t forget to measure settlement accounting if you completed a lump sum window in 2016! Some small and mid-sized plans may not be familiar with this requirement, and it can significantly increase your 2016 pension accounting expense.
  • Using the Citi above-median yield curve could increase discount rates by roughly 12 basis points.
  • Now may be a good time to consider strategies that lock in some of this year’s investment gains. These could include exploring an LDI strategy to more closely align plan assets and liabilities, or offering a lump sum payout window for terminated vested participants in 2017.

 

Pension Lump Sums Likely More Expensive in 2017

Lump sum windows and other pension risk transfer strategies continue to be popular among many defined benefit (DB) pension plan sponsors. Paying lump sums to terminated vested participants can reduce long-term plan costs and risks by permanently eliminating these liabilities. However, the cost of the lump sum payments is heavily influenced by the underlying interest rate and mortality assumptions.

The IRS recently released the October 2016 417(e) interest rates. Although many DB plans will likely use the November or December rates as their 2017 lump sum payment basis, the October rates are good indicators of what 2017 lump sum costs might look like. This post shares a brief update of the impact these rates could have on 2017 lump sum payout strategies.

Lower Interest Rates Will Increase Cost of Lump Sums

So, what’s the story for 2017? The table and chart below show the possible difference in lump sum values at sample ages assuming payment of a $1,000 deferred-to-65 monthly benefit. The calculations compare the November 2015 rate basis (used by most plans for 2016 lump sums) to the October 2016 basis.

lump-sums

november-2017-ls-rate-update-table

The dollar increase in lump sum value is relatively consistent around $10K to $12K. This translates to a 5% cost increase at the very late ages, versus a nearly 30% cost increase at younger ages. Note that if we adjust for the fact that participants will be one year older in 2017 (and thus one fewer years of discounting) then this increases the costs by an additional 5% at most ages.

Interest rates dropped significantly in the first half of 2016 and have only recently begun to rebound. This increases lump sum costs because lump sum calculations increase as interest rates decrease, and vice versa. Below is a comparison of the November 2015 and October 2016 417(e) lump sum interest rates. Note that the second and third segment rates are 70+ basis points lower than last year.

415e-interest-rates

What else should plan sponsors consider?

  1. If you’re still considering a lump sum payout window, you’ll want to carefully weigh the additional costs of the 2017 lump sum rates compared to 2016. However, there’s still the chance that rates could rise substantially before year-end.
  2. Even with lower interest rates pushing up lump sum costs, there are still incentives to “de-risk” a plan now. These include (a) large ongoing PBGC premium increases and (b) the potential for new mortality tables to further increase lump sum costs (likely in 2018).
  3. In addition to lump sum payout programs, plan sponsors should consider annuity purchases and additional plan funding as ways to reduce long-term plan costs/risks. Some plan sponsors are also pursuing a “borrow to fund and terminate” strategy.

 

What’s the Impact of 2017 IRS Retirement Plan Limits?

The IRS just announced the 2017 retirement plan benefit limits, and there are some notable changes from 2016. What does it all mean for employer-sponsored retirement plans? Here is a table summarizing the primary benefit limits, followed by our analysis of the practical effects for both defined contribution (DC) and defined benefit (DB) plans.

Qualified Plan Limit 2015 2016 2017
415 maximum DC plan annual addition $53,000 $53,000 $54,000
Maximum 401(k) annual deferral $18,000 $18,000 $18,000
Maximum 50+ catch-up contribution $6,000 $6,000 $6,000
415 maximum DB “dollar” limit $210,000 $210,000 $215,000
Highly compensated employee (HCE) threshold $120,000 $120,000 $120,000
401(a)(17) compensation limit $265,000 $265,000 $270,000
Social Security Taxable Wage Base $118,500 $118,500 $127,200

 

Changes affecting both DB and DC plans

  • Qualified compensation limit increases to $270,000. High-paid participants will now have more of their compensation “counted” towards qualified plan benefits and less towards non-qualified plans. This could also help plans’ nondiscrimination testing if the ratio of benefits to compensation decreases.
  • HCE compensation threshold remains at $120,000. For calendar year plans, this will first affect 2018 HCE designations because $120,000 will be the threshold for the 2017 “lookback” year. When the HCE compensation threshold doesn’t increase to keep pace with employee salary increases, employers may find that more of their employees become classified as HCEs. This could have two direct outcomes:
    • Plans may see marginally worse nondiscrimination testing results (including ADP results) if more employees with large deferrals or benefits become HCEs. It could make a big difference for plans that were previously close to failing the tests.
    • More HCEs means that there are more participants who must receive 401(k) deferral refunds if the plan fails the ADP test.

DC-specific increases and their significance

  • The annual DC 415 limit increases from $53,000 to $54,000 and the 401(k) deferral limit remains at $18,000. A $1,000 increase in the overall DC 415 limit may not seem like much, but it will allow participants to get a little more “bang” out of their DC plan. Since the deferral limit didn’t increase, this means that any additional DC benefits will have to come from higher employer contributions. Individuals can now receive up to $36,000 from match and profit sharing contributions ($54K – $18K).
  • 401(k) “catch-up” limit remains at $6,000. Participants age 50 or older still get a $6,000 catch-up opportunity in the 401(k) plan, which means they can effectively get a maximum DC deduction of $60,000 ($54K + $6K).

DB-specific increases and their significance

  • DB 415 maximum benefit limit (the “dollar” limit) increases to $215,000. This limit finally increased after being static for three straight years. The primary impact is that individuals who have very large DB benefits (say, shareholders in a professional firm cash balance plan) could see a deduction increase if their benefits were previously constrained by the 415 dollar limit.
  • Social Security Taxable Wage Base increases to $127,200. This is a big jump from the prior $118K limit and effectively reflects two years of indexing (the limit couldn’t increase last year because the Social Security COLA was 0% and caps the wage base increase rate). With regards to qualified retirement benefits, a higher wage base can slightly reduce the rate of pension accruals for highly-paid participants in integrated pension plans that provide higher accrual rates above the wage base.

 

Closed DB plan nondiscrimination testing relief extended for 2017

 arms-in-air

Employers with “closed” DB pension plans (i.e., closed to new entrants, but benefits continue to accrue for existing participants) received another extension of nondiscrimination testing relief in IRS Notice 2016-57. This will help these employers demonstrate compliance with existing nondiscrimination testing rules while waiting for final regulations likely to be effective starting in 2018.

Background

Closed DB pension plans often run into unintended nondiscrimination testing problems. Why? Generally there is higher turnover among non-highly compensated employees (NHCEs) vs. highly compensated employees (HCEs). The NHCEs positions are filled with new employees who are not eligible for the closed DB plan, so the DB plan gradually becomes “concentrated” with HCEs. This will eventually cause the plan to fail the nondiscrimination testing requirement that pension plans not cover a disproportionate share of HCEs.

The IRS acknowledged this unintended consequence with Notice 2014-5 which provided temporary relief for DB plans with a soft-freeze date prior to December 31, 2013. The relief applied to the 2014 and 2015 plan years and allowed aggregated nondiscrimination testing of DC plans and closed DB plans without having to pass the usual “gateway” requirements, as long as the DB plan passed testing on a standalone basis in 2013. This was a significant development because gateway allocations can be very expensive and require per-participant allocations of up to 7.5% of pay. The alternative was to freeze all DB plan accruals so that the coverage requirements no longer applied to the DB plan.

Relief Extended

The relief in Notice 2014-5 was extended to the 2016 plan year in Notice 2015-28, and proposed regulations were issued on January 29, 2016. Since those regulations likely won’t be finalized and effective until the 2018 plan year, the IRS is now extending the temporary nondiscrimination testing relief for the 2017 plan year as well.

Although this relief is welcome news to plan sponsors, they should not lose sight of the fact the closed DB plan still needs to pass nondiscrimination testing when aggregated with the employer’s DC plan(s). This shouldn’t be a problem in most cases, unless the DB plan provides such large benefits to HCEs that the aggregated plans fail the 401(a)(4) benefits testing.

Sponsors of small and mid-sized closed DB plans should also keep in mind that eventually 401(a)(26) minimum participation requirements could become a problem. These rules require that the smaller of (a) 40% of active employees or (b) 50 active employees participate in the DB plan. In high turnover industries, those thresholds may not be far on the horizon.

 

False alarm! IRS withdraws controversial proposed cross-testing regulation provisions

A couple of months ago, the IRS proposed some changes to the §1.401(a)(4) nondiscrimination testing regulations.  On Thursday, they withdrew the part of those proposed regulations that was bad news for plan sponsors, as noted in our prior post.

We are pleased the IRS has reconsidered the unintended consequences benefit formula restrictions and “facts and circumstances” based determinations could have on employers’ willingness to sponsor qualified retirement plans.