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.