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.