So your 50-something client realizes (with or without your help) that or he or she may not have enough money “socked away” for a comfortable retirement. A defined benefit pension plan may be the ideal solution.
Defined benefit plans have been out of vogue for some time, due in part to their relative lack of flexibility and potentially costly administration. However, a DB plan may be just the thing for those who need to build a nest egg in short order.
A well-designed DB plan lets business owners save, on a tax-deductible basis, from 5 to 10 times the amount of money permitted in a defined contribution plan. This is possible because the IRS controls the plan benefit, not the contribution, as it does with 401(k)s, SEPs and IRAs. As long as the plan gives the same benefit to all employees, the IRS permits the company to contribute whatever amount necessary to fund the benefit.
For example, a company could adopt a DB plan that promises retired employees 50% of their salary (up to a salary cap of $220,000 in 2006) when they reach 65. If the workforce consisted of just two employees, the plan might go something like this:
Employee #1, age 55, is the owner of the business and earns $200,000 per year. Employee #2, age 30, earns $40,000 per year. The DB plan promises to pay employee #1 $100,000 per year after retirement and employee #2 $20,000 per year at retirement. Because the benefits are applied in a non-discriminatory way, the IRS is happy.
The company now must set aside money to deliver on the plan promises. Specifically, the firm has 35 years to accumulate enough money to fund a $20,000 annual benefit to employee #2, but it only has 10 years to fund the promise to pay $100,000 per year to employee #1. The company will be allowed a deductible pension deposit in the neighborhood of six figures. If the company is profitable and looking for big deductions, it too is happy.
Because of the differences in their ages and compensation, most of the contribution for this plan will go to build a fund large enough to provide the benefit promised to the owner of the business. Now, the business owner is happy.
One of the most common questions from clients planning for their retirement is “How much will I need?” While the average boomer may need from 70% to 80% of working income during retirement, that number may actually be higher or lower. Intelligent testing is a good way to determine how much your client will need.
For example, the owner of our imaginary company who makes $200,000 a year pre-retirement may well want $200,000 or more following retirement to live the life he feels he has earned. By contrast, if that same business owner is making $2 million a year before retirement, the 70%-80% “rule of thumb” may not necessarily apply.
So where do you start?
The first thing is to make sure the accumulation mechanisms are being used effectively. Encourage clients to make the maximum contributions to their 401(k) plans and take advantage of the make-up provisions, as people over 50 can put extra money into their plans. (If they don’t have a 401(k) plan, you can certainly help implement one.) While this won’t make up for all of those years of not saving, it will provide a good jumping-off point.
One drawback to DB plans is that contributions are not discretionary. Unlike a profit sharing plan in which contributions can be made or not made, depending on the whim of the business owner, you are locked into a DB plan once you’ve started one. This can be problematic for small businesses that struggle to make a profit every year. In addition to the contribution requirement, there is also an annual actuarial expense to maintain the plan’s status with the IRS and the Department of Labor.
Whether clients see these aspects of a DB plan as a negative or a positive is a matter of perspective. The reason many baby boomer business owners are in this retirement pickle is because they had to spend rather than save during their working years. Being put into a position in which a contribution must be made might be exactly what the boomer needs to get the job done and have the retirement income desired.
Defined benefit plans are not for every company. But for those that have predictable profits and a mature business model, the plans offer good opportunities to plan for that comfortable retirement.