Individual defined benefit plans are appealing to the self-employed.

    Long misunderstood and seldom appreciated, except by a lucky few whose advisors had the inside scoop, defined benefit (DB) plans may be just what the baby boomer generation needs to make up for lost time. Now, there is an opportunity to leverage today's technology and the financial services industry to make these supercharged pension plans available to the masses. With more people looking at starting their own businesses in response to corporate downsizing and overseas outsourcing, its time for business advisors of all types to get educated, or be left on the outside looking in. Here's a start.

What The Plans Are
        Technically, an individual DB plan is a defined benefit pension plan maintained by a self-employed individual (whether incorporated or not) who has no other employees. Similar terms, however, often are used to describe plans maintained by other small businesses (those with employees) as well. A defined benefit plan is designed to provide a participant with a specified benefit at retirement, with the employer making contributions over the working lifetime of the participant to fund the promised benefit. Benefit amounts generally are based on compensation, years of service or a combination of the two. Actual benefits can be paid out in the form of a monthly annuity or in a lump sum.
This type of plan has been around for decades, and saw widespread use during the 1970s and early 1980s. However tax reform legislation, which came about in the mid-1980s, made them much less desirable to maintain. For much of their history, the only way to establish such a plan was through an insurance company, a third-party administrator or an independent actuarial consulting firm. This was generally considered to be a complex and expensive process at best, and DB plans were largely avoided in favor of the much simpler defined contribution plans available at the time-money purchase pension plans and profit sharing plans.
    In the last few years, additional (more favorable) changes were made to the rules governing retirement plans in general, and DB plans in particular, once again making them an attractive alternative for many small business owners. This has caused a resurgence in the popularity of individual DB plans, with several large financial institutions now adding them to their already popular Individual 401(k) Plan offerings.
 
Who Is A Good Prospect?
    Most often, DB plans are associated with those business owners who are closer to retirement and haven't yet accumulated sufficient assets to provide for their financial security. Since the maximum benefit limitations at a given retirement age are generally the same regardless of a person's current age, the closer one is to retirement, the larger the annual contribution that is required to provide for the ultimate benefit from the plan. Another key criterion generally considered is a desire to contribute $50,000 or more per year to a retirement plan, since contributions of $42,000 to $46,000 can be made to the simpler, less expensive individual 401(k) plans. This leaves us with the basic profile of someone in their fifties who wants to contribute $50,000 to $100,000 annually for the next ten to 15 years as a fairly typical candidate. At the extreme, high-income earners in their sixties can actually contribute as much as $200,000 to $250,000 annually, should they desire to do so. The larger contribution amounts generally help justify the higher annual administration fees associated with the DB plan.
    There is, however, another profile that may be equally well suited for an individual DB plan. Consider someone as young as age 35 or 40, possibly with one source of income from employment with a large employer providing the usual suite of employee benefits, and a completely separate source of earned income from another source, none of which is required to meet current living expenses. With a defined contribution plan (including an individual 401(k) plan), the maximum deferral would be roughly 20% of the individual's supplemental earned income. However, an individual DB plan in some cases can be designed to allow substantially all of this income to be set aside for retirement. Limits do apply, depending on the person's age and the history of the earned income, but an individual DB plan can often produce a very desirable result in a situation such as this.
 
What Does It Cost?
    There are many components to the actual cost of setting up and maintaining any type of retirement plan for a small business owner, and individual DB Plans are no exception. There might be consulting fees for the plan design illustrations, although today many providers will do the design work for free, as it is considered a part of their overall marketing expense. There is generally a "set up" fee-the cost of preparing the plan document and related forms, and possibly filing it for approval with the Internal Revenue Service, which can cost another $1,000 to $3,000, depending on the source. Preapproved prototype plans are frequently used to help keep this cost down for most individual plans.
    Then there is the recurring annual administrative fee-the cost to perform the routine actuarial calculations, prepare the government filings and generally to provide information and consulting support to the plan sponsor from time to time, which can run anywhere from $1,000 to $2,500 per year, again depending on the source. Finally, there is the ongoing cost associated with investing the plan assets. This could include mutual fund operating expenses, commissions paid to trade in individual stocks or bonds and frequently a fee for professional investment advice. Many of the "bundled" providers in today's market combine some or all of these costs into a single annual flat dollar fee, an asset-based fee or a combination of the two. Generally, the less "customized" the arrangement, the lower the fees are going to be, but watch out: Sometimes package deals that tout very low cost or possibly even free administration contain heavy subsidies to the provider in the way of investment-related fees.

Why The Limited Interest?
    Assume for the moment that a compelling case has been made for the individual DB plan in general, and a particular business owner fits the profile regarding age, income level and appetite for deferral. Why does this individual typically end up with a much simpler (although in the end often far costlier, if one considers the lost opportunity) defined contribution plan? Because people in the financial services industry, and the consuming public in general, are either unaware of the existence of the individual DB plan or consider it too complicated and too costly to pursue. Since these types of plans are generally "sold" and not "bought," if the sales agent lacks the proper knowledge or incentive to present the individual DB plan option, the end user is seldom aware that such a product even exists. Hence, the preponderance of individual 401(k) plans in the small-employer market.
    Another general feeling is that DB plans are far too restrictive and require too large a commitment on behalf of the business owner. While it is true that contributions are not discretionary, there are ways to make the annual funding requirement rise and fall with the level of profitability from the business and making the commitment much more manageable. Ultimately, as the business owner's objectives for the plan change over time, the plan can be amended to raise or lower benefits (and contributions) in general, or the plan can be terminated and the assets rolled over into an IRA. If this can be communicated in a way that the business owner can understand, the barrier to growth in the individual DB plan market begins to crumble. No hard and fast rules apply to how often a plan can be amended, or how soon it can be terminated, but the IRS seems to like some degree of consistency and longevity in the typical DB plan. 

Jeff Berends is executive vice president of CCA Small Business Group LLC in Chicago and co-developer of the MyMax individual retirement plan. Berends, who is based Denver, has designed defined benefit retirement plans for small businesses for more than 25 years.