There was a time when defined benefit (DB) pension plans were the only retirement game in town. Employers took responsibility for setting up the plans, funding them, and investing prudently to ensure that management and employees could retire with a regular income for life. That was before defined contribution (DC) plans came about, shifting the burden of saving and investing for retirement from employer to employee, and in many ways simplifying the retirement plan process for business owners, but limiting contribution amounts and providing little guarantee that what is saved will actually be enough to retire on–for employers or employees.
There is an opportunity for advisors to help clients who own small businesses to set up a DB plan. It’s not for every small business, but in certain situations, the DB plan can be very helpful, particularly if owners are age 48 or older, have a small or ultra-small business, and are in their peak earning years. “There’s a much larger contribution opportunity in a defined benefit plan,” says Philadelphia-based R. David Danziger, partner and founder of The Law Offices of R. David Danziger.
One of the key reasons DB plans are popular again is a change in the law governing pension plans. Before the repeal of Internal Revenue Code (IRC) section 415(e), the code limited the total amount of benefits and contributions a person could accumulate in combined DB and DC pension plans offered by one employer.
The repeal of section 415(e) means that if an employer had a DC plan and amassed wealth in that, she can now start a DB plan and build assets there as well, without the limits that applied before repeal of section 415(e). “It’s a clean slate, clean opportunity for people, even though they’ve run defined contribution plans for many years,” according to Danziger.
Congress is weighing in on pension plans as well. Rep. John A. Boehner (R-Ohio) has introduced H.R. 2830, a bill that allows employers to make investment advice available to employees, and addresses underfunding of defined benefit pension plans. The bill was voted on by the House Education and Workforce Committee in June, and now goes, with a similar Senate Finance Committee bill passed in July, to the House Ways and Means Committee.
“Why defined benefit plans when there’s so much press saying that defined benefit plans are over?” asks Danziger, whose firm designs retirement plans. “Defined benefit plans really are in trouble with larger employers, but there is a tremendous opportunity for the ultra-small employer–the investment advisor who is working by themselves or maybe with one or two staff people, maybe it’s a husband-and-wife team, or it’s [a business made up of] family members. In these small businesses, defined benefit plans are fabulous–I call them the ultimate catch-up contribution program,” he says. “Catch-up” refers to higher dollar amounts that you can add, at age 50 or older, to your retirement plans. The catch-up amounts for DC plans are $4,000 in 2005 and $5,000 in 2006. That brings the total for certain types of 401(k) plans to a total of $46,000, according to Danziger, but in a DB plan, “the contribution limits are so much higher, a person in their 50s can be looking at a contribution of $100,000 or more.”
How Different Are the Plans?
The differences between the two types of plans are striking. “Max [contribution] numbers in defined contribution plans are much simpler, because as the name implies [the IRS] defines what the contribution is” as a maximum dollar amount, and a maximum percentage of pay.
“A defined benefit plan doesn’t so much limit what goes in–it could be 100% of income. What [the IRS] defines is the target benefit at retirement. Just as a rule of thumb, we talk about accumulating a fund of $2 million in your early 60s, let’s say 62,” says Danziger. The limit on what the beneficiary can take out each year during retirement is adjusted for cost of living ($170,000 for 2005). “You need to contribute enough so that you’ll have that benefit at retirement,” he says. A 50-year-old has only 12 years to accumulate that benefit, so very substantial contributions are necessary to get to that target amount. “The contribution can be 100% of the business income for a self-employed person. It can actually generate a loss in a corporation; you can put in more than your income. It’s a tremendous opportunity to reduce income taxes and to save at a very rapid clip.” An actuary calculates contribution amounts using interest rate assumptions, the individual’s age, and salary history.
Advisors may want to develop referral relationships with the other professionals that help clients set up DB plans. Danziger says he gets many clients via referrals from investment advisors, and vice versa. In addition to an investment advisor, clients need to consult with someone who can write the plan, such as Danziger, an actuary, and a third-party administrator (TPA) to maintain records and reports and consult with the advisor on contribution strategy. Danziger offers TPA services, and some actuaries do as well.
The Best Candidates
Defined benefit plans can be extremely valuable for small businesses with 10 or fewer persons, or ultra-small firms with three or fewer employees, or even family businesses. To decide if a DB plan makes sense, Danziger says to consider three main issues: employee demographics, income levels, and investment return. Consider how many employees a firm has, their ages, and whether employees are owners, partners, or staffers. A firm with four partners and one employee is a better candidate than a firm with one owner and four support people. Small family firms may be ideal because of the wealth transfer aspect of DB plans.
Income levels of the company need to be steady, rather than sporadic with one colossal year and then mediocre years, because employers who sponsor DB plans must commit to make the contributions–for all participants–each year until retirement. It’s not like profit sharing, in which an employer’s contribution amounts could change from year to year based on a company’s profits.
Generally, investment returns in the portfolio in defined benefit plans are assumed by the actuary to be average, reasonable, and consistent with preservation of capital. When working with clients, registered investment advisors could be considered to have fiduciary responsibility, as could brokers if they have discretion over the investment portfolio. Ask yourself, says Danziger, “Are you giving advice for a fee?”
Although DB plans are not appropriate for every business owner, and can be more complicated to set up than DC plans, DB plans can add great value under the right circumstances, and are an option worth considering for clients who own small or ultra-small businesses.
Staff Editor Kate McBride can be reached at [email protected]