Retirement Plans for the Small Business Owner

Most people worry about their financial security in retirement, partly because of the many news stories about under-funded company pension plans at GM, Ford, and many other large US corporations. Add to that shaky stock market returns over the last five years and a looming shortfall in the social security system, and there is plenty to be concerned about. Of course none of these problems are new, but they have been getting more attention recently, because the wave of retiring baby boomers will start straining the retirement system soon.

Advice on retirement plans usually focuses on options available to employees. Business owners often are in a very different situation, because they tend to reinvest their earnings into their company rather than fund retirement accounts. When the owner starts thinking about retirement, it is often too late to achieve retirement security by starting an IRA. The low annual contribution limits prevent the business owner from contributing a significant amount to the plan during the relatively short period of time until retirement. In this article we will discuss a class or retirement plans that favor small business owners in this situation.

Retirement plans can be broadly divided into two classes: defined contribution plans and defined benefit plans.

Most Americans are familiar with defined contribution plans like profit sharing plans and 401(k) plans. The key characteristic of a defined contribution plan is that there is a limit to how much money the individual, and in some cases the employer, can contribute to the plan each year. The relatively low annual contribution caps limit the size of such plans, especially if they are started late in life.

Defined benefit plans take the opposite approach. This type of plan guarantees a specific monthly payment to retirees. Traditional company pension plans work this way. For defined benefit plans, the plan administrator calculates the necessary level of assets required to pay out the retirement benefits. The plan sponsor then funds the retirement plan with the required amount. Many different types of defined benefit plans exist in the pension market place. The features highlighted in this article are only available in certain non-traditional plans.

For small business owners in high tax brackets this class of retirement plans is worth considering. The owner can determine the desired monthly retirement benefit and fund the plan with the amount necessary to provide his or her retirement income. The annual contributions to such a plan can be very sizable, which provides income tax relief and a variety of other benefits.

In order to illustrate how this type of defined benefit plans works, we will use as an example a married 58 year old couple who owns a business with no employees. Let’s assume that the business generates about $1.25 million in pre-tax earnings per year and that the defined retirement benefit for the couple is a payment of $29,166 per month. This example illustrates maximum benefits. Virtually any lesser amount can be achieved.

Some of the main benefits of defined contribution plans include:

• Income Tax Benefit: The maximum our hypothetical business owners could contribute to a defined contribution plan is about $84,000 per year. However, with a defined benefit plan, their contributions could be as high as about $700,000 per year for 10 years until they retire Assuming a 40% tax bracket, this could result in about $280,000 of annual income tax savings per year.
• Retirement Benefit: In our example, the married business owners receive $29,166 per month of taxable income when they retire and the payments would continue as long as either spouse survives. To support this level of retirement benefits, a defined contribution plan would need at about $6.8 million in assets. Based on the same assumptions it would take 34 years to build up a defined contribution account to these levels. With a defined benefit plan, the same amount of funding can be contributed over the course of just one or two decades.
• Estate Tax Benefit: Defined benefit retirement plans can be set up so that the assets are no longer part of the business owner’s estate and therefore not subject to estate or gift tax. Defined contribution plans, however, are in general part of the estate and subject to estate tax.
• Asset Protection: Most businesses are at risk of getting sued. Assets contributed to retirement plans are shielded from claims by creditors or arising from litigation. This feature is particularly attractive for high risk businesses such as medical doctors’ offices. Although this advantage applies equally to defined contribution accounts, a typical defined benefit plan will contain more assets than a defined contribution plan.
• Death Benefit: Defined benefit plans can be set up to include a death benefit in addition to the retirement benefits discussed above. In effect, this allows the business owners to purchase a life insurance policy as part of their retirement plan out of pre-tax dollars.

As stated above, one significant advantage to defined benefit plans is that the contributions to such plans can be much larger than the maximum contribution to defined contribution plans. This is because tax law allows business owners to fund the plan with sufficient assets to cover the pension liability. Since the business owners in our example have only about ten years to fund the plan and the retirement benefits are rather generous, the annual funding requirements are relatively high. This simple fact underlies many of the attractive features of defined benefit plans for business owners.

Another advantage of defined benefit plans is that they are flexible enough to be optimized for each business owner’s individual situation. For example, a childless business owner needs a different retirement plan that somebody whose children are working in the family business. However, it is important to note that this flexibility comes at the price of increased complexity.

Generally at least some of the benefits should be available to business owners who

• Are in one of the highest tax brackets;
• Do not spend everything they make;
• Have limited time left until retirement; and
• Have few employees.

While defined benefit plans can have significant advantages for business owners, there are also drawbacks and risks to consider:

• Ownership: Any contributions to the plan by its sponsor becomes the property of the plan, reducing the business owner’s income. This helps with estate tax planning, but reduces the heirs’ inheritance. However, defined benefit plans can be constructed to mitigate these effects. The most elegant solution is for the business owners to employ their heirs. As employees, the heirs can participate in the retirement plan. Their inheritance will consist of the business owners’ estate as well as a retirement plan that is pre-funded with whatever amount the business owners did not consume. Additionally, there are ways to combine defined benefit plans with life insurance policies to generate rather sizable cash distributions to the heirs after both of the original business owners have died.
• Liability: In a difficult business environment, a defined pension plan can be problematic. The sponsoring entity has to be able to make the necessary payments to fund the plan year after year. Business owners have to determine if their business can support this commitment. That said, in the event of business downturn, plans can be frozen (and unfrozen) and plan documents amended to lower contributions and future benefits.
• Complexity: Defined benefit plans are not as simple as defined contribution plans. Generally, an actuary designs the plan and ensures that it remains in compliance with IRS regulations and requirements.
• Universality: The plan must cover all employees subject to eligibility and vesting requirements that the plan sponsor may impose. This puts businesses with a large number of employees at a disadvantage, but even for businesses with hundreds of employees, establishing such a plan can still be advantageous to the owners.
• Investment Risk: The plan sponsor bears the investment risk. Actuaries assume a conservative growth rate for the plan assets, usually 5%, to calculate the required funding. If actual returns lag the assumed rate, the plan will be under-funded and it is the plan sponsor’s responsibility to restore the assets to the required level.

Defined benefit plans are certainly not suitable for everyone, but for certain business owners they may provide an attractive way to combine tax savings and estate planning. Furthermore, since the owners and all vested employees enjoy the same retirement benefits, such a plan can be a useful tool to hire and retain talented employees.

We discussed some of the benefits of defined benefit plans, but we also mentioned all the negative headlines about under-funded pension liabilities. How can these plans be good for business owners and major problems for other organizations at the same time?

There is a key difference between a business owner who is a plan participant and an investor in a public company: The business owner benefits from diverting earnings into a pension plan as we discussed above. For an investor in a public company, on the other hand, this is an undesirable use of earnings. It takes away from dividend payments or investments into future growth, the two main ways an investor benefits from the company’s earnings.

There are many providers who can set up defined benefit plans. To realize the maximum benefit from these plans, they should be tailored to each individual business owner’s situation. Generic defined benefit plans usually do not provide the same level of benefits. Especially with the more complex versions it is prudent to select an administrator whose plan has been explicitly approved by the IRS.

Martin Gremm, PhD
Pivot Point Advisors, LLC
(832) 778 7101

(c) 2006 Pivot Point Advisors, LLC. All rights reserved. The material may not be re-published or re-used except with prior written permission.