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Choices, Choices, Choices

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With so many alternatives, small business owners need help from advisors in picking the right retirement plan

Self-styled gurus, sales coaches and others whose raison d’?tre is helping financial advisors succeed in their practices have long touted the benefits of specialization. Perhaps for no segment of the market does this clarion call ring so true as it does for the niche field of small business pre-retirement planning.

Consider the varied options available. Respecting qualified retirement plans, there is the defined benefit or pension plan, the defined contribution plan (e.g., 401(k)), the profit-sharing plan, the money purchase plan and the employee stock ownership plan or ESOP. There are, too, simplified plans, such as the SIMPLE IRA and SEP IRA.

Permutations of these solutions have surfaced in recent years, such as the 412(i) defined benefit plan, and since passage of the Economic Growth and Tax Relief Reconciliation Act of 2001, the solo and safe harbor 401(k) plans with profit-sharing features.

Also to be learned are the large bodies of law governing these savings vehicles. As regards qualified plans, they include the Internal Revenue Code and the Employee Retirement Income Security Act, which, to paraphrase one advisor, is so complex that even lawyers have trouble navigating it.

“To excel in this space, advisors need to know all the different plan types cold–what they are, how they work, where the opportunities and benefits are,” says Michael Kitces, director of financial planning for Pinnacle Advisory Group, Columbia, Md. “Otherwise, they’ll try to shoehorn people into the two plans they know. That may or may not be ideal for the client.”

In determining the right package for the small business client, advisors need to consider a range of factors. High on the list, sources say, is the amount of money that clients intend to put away, and for whom.

A self-employed professional earning $100,000 or less may view the solo 401(k) plan as an effective solution to fund up to $43,000 annually in retirement savings. But business owners with significantly larger sums to stash away might opt for a 412(i) or other defined benefit plan, which permit very large pre-tax contributions and tax deductions–a not insignificant selling point for producers.

Also to weigh are the purpose of the plan and the finances available to facilitate objectives. Does the owner intend it primarily for owners/key people or for all personnel as part of an employee-retention strategy? Is the budget sufficiently large to support all participants and, if necessary, third-party administration of the plan?

Business owners additionally need to factor in the job titles, ages and incomes of the various employees. If the principals of, say, a start-up technology firm are much closer to retirement than the rest of the staff, then the company may want a “cross-tested” or “new comparability” solution.

A hybrid of the defined benefit and defined contribution plans, the solution uses defined benefit actuarial tables to determine plan contributions the employer has to make to secure a fixed benefit for each of the participants. Contributions to retirement accounts of boomer-age employees may, therefore, dramatically exceed that of their 20-something peers.

“It’s a very complicated sale,” says Bob Rockwell, a financial planner and investment department manager at CCB Financial Services, Sandy, Ore. “I understand the concept, but I’ve never found anyone who is willing to go through the expense because you have to hire an actuary to do it right.”

Complicated or otherwise, retirement savings plans are achieving low penetration levels within small firms. A 2004 Wells Fargo Gallop Survey, titled “Small Business Owners Optimistic about Their Personal Finances,” found that most owners (54%) still depend primarily on the value of their business to fund their retirement.

Among entrepreneurs who do have retirement accounts, defined contribution plans accounted for 41% of owners’ business and/or personal retirement savings. This contrasts with 28% and 50%, respectively, who are invested in defined benefit plans and IRAs.

Why the comparatively higher percentage for IRAs? Experts point to their low costs and ease of administration. A popular employer-sponsored plan falling within this category, the savings incentive match plan for employees or SIMPLE plan, is not subject to the nondiscrimination and top-heavy rules of ERISA that generally apply to qualified plans.

Eligible participants contribute money to a SIMPLE IRA or fund an individual retirement annuity through payroll deductions, limited to $10,000 in 2005. Employers can make elective matching contributions (up to 3% of an employee’s total compensation), or make non-elective mandatory contributions.

“SIMPLE plans are great for start-up companies where the goal is to provide a package that’s low cost and easy to administer,” says C. Zach Ivey, a financial planner with First Financial Group of the South, Birmingham, Ala.

Leon Russo, a financial planner with Leon Russo & Associates, Ventura, Calif., also lauds the plans’ flexibility with respect to matching contributions. Employers can, for example, gradually increase the match for new hires from 1% to 3% of pay during the first three years of employment.

Another simplified retirement plan that falls outside of ERISA law, the simplified employee pension plan or SEP IRA, lets employers make tax-deductible contributions up to 25% of an employee’s pay or a maximum of $42,000 in 2005 (indexed annually for inflation, whichever is less).

Unlike SIMPLE plans, however, SEP IRAs do not entail employee contributions. But they are subject to top-heavy testing. If the test indicates the plan favors key employees, current law mandates a 3% minimum contribution on behalf of each participant.

SEPs, however, cost almost nothing to establish and maintain–just $10 per year if administered through a mutual fund company. And, apart from filing an IRS Form 5305-SEP to start the plans, employers generally don’t need to complete any IRS or Department of Labor reports.

Ken Steele, a senior financial planner at MetLife, New York, N.Y., says SEP IRAs are fine for firms that see no need to skew retirement benefits to key employees. But he finds that a decreasing number of his clients fall into this category.

“The SEP plan is the epitome of what’s good for the goose is good for the gander and the gosling,” he says. “Everyone gets the same percentage of whatever.

“I have clients for whom I established a SEP plan years ago because it was so easy,” he adds. “But now, as their companies are doing better and making more money, I tell them, ‘If you do the math, you’ll see that last year you wrote a check for $50,000 into the SEP. Of that amount, you got 40% and everyone else got 60%. Do you see anything wrong with that picture?’ And of course they do.”

The better options, Steele and others insist, are 401(k) plans with profit-sharing features. These include the solo 401(k) for sole proprietors and the safe harbor 401(k) plan for firms with multiple employees.

These plans allow employers a greater tax deduction–and hence larger retirement benefit–than do their SEP and SIMPLE counterparts. Participants can borrow against the plans. And they can use retirement plan cash accumulations to buy permanent life insurance, typically universal life policies.

For 2005, owners can make salary annual deferrals of $14,000 and if they’re aged 50 or older, catch-up contributions of $4,000. Adding in the maximum employer contribution of $25,000 yields a total contribution of $43,000.

“We expect to see exponential growth in demand for these plans over the next two to three years,” says George Kozol, a senior vice president of marketing at Security Mutual Life Insurance Company of New York, Binghamton, N.Y. “They’re a bit more complicated than alternatives in terms of plan design, but they’re more effective for the business owner or self-employed individual.”

Kozol adds that approximately 1,000 of Security Mutual’s independent producers are marketing solo and safe harbor 401(k) plans under the company’s “micro(k)” and “Dash 401(k)” labels. Premium dollars garnered from sales of the product, he estimates, are up 100% for each of the last two years.

Security Mutual’s experience regarding the solo 401(k) is mirrored industrywide. Chris Brown, who tracks solo 401(k)s for Financial Research Corp., a Boston-based consulting firm, says entrepreneurs have poured about $2.8 billion into these plans since their launch in 2002. That is expected to jump to $5 billion by year-end 2005.

Another qualified retirement plan with a life insurance component, the 412(i) defined benefit plan, also has received much buzz in recent years–but not all of it positive. The plan, which affords employers very large pre-tax contributions and tax deductions, has come under heightened IRS scrutiny because of much publicized abuses (e.g., policy owners who received distributions of cash values at low tax cost because of artificially inflated surrender charges).

Kitces believes the scandals will depress sales of life insurance policies inside of qualified plans. But he notes that as long as prospective buyers acquire the policies as an incidental benefit to the plans–a legitimate use under IRC rules–then they should have no reason to fear a government audit.

Advisors, for their part, can help ensure they remain in good standing with clients and federal regulators by limiting counsel to their areas of expertise and, when necessary, referring clients to another professional.

Rockwell learned this the hard way. One of the “scariest moments” in his career, he says, occurred when he offered a client tax advice concerning a SEP plan that, unbeknownst to Rockwell, was improperly funded because participants had not conformed to certain family attribution rules of ERISA law.

“One lesson I can impart to advisors: never give tax advice,” he says. “It’s so easy to try to be helpful. But unless you’re doing someone’s taxes, you don’t know what can pop up.”

Advisors also need to be mindful of complications that can arise when plan participants, particularly top-tier executives, insist on parity in retirement benefits. Neil McCarthy a financial planner at McCarthy & Associates, Roswell, Ga., cites a 401(k) profit-sharing plan for a law firm that required much fine-tuning. The reason: concerns that one of the partners might derive an unfair advantage because the firm also employed his wife.

Designing the plan right, however, is generally a smaller challenge than two others that advisors all too often confront: getting quality time with clients, and motivating them to implement the recommended plan.

For Rockwell, an effective technique is to send prospects a postcard, the message of which puts a twist on an old educational slogan from a TV ad: The card reads, ‘a tax break is a terrible thing to waste.’

“I use that a lot,” says Rockwell. “Once you’ve wasted your tax break, you can’t get it back. If you wait an extra 5 years to buy into a plan, you might end up paying an extra $100,000 to Uncle Sam.”

Adds Kitces: “What’s always a high-value conversation for clients is showing them what taxes they won’t pay this year because they worked with me. That’s certainly a tangible benefit.”