In fact, while frequently overlooked as too complicated and/or too expensive, a traditional pension, or defined benefit, plan may well be the best way to make sure a small business owner has retirement income, according to Lorraine Dorsa, Principal, Lorraine Dorsa & Associates of Jacksonville Beach, Florida.
Defined benefit programs are plans where the ultimate benefit is defined, rather than the contribution, as with defined contribution plans. They are generally designed to provide a specific monthly benefit at retirement, though other payment options are available.
Speaking at the ABA Retirement Services Conference in Washington, D.C., she noted that aging baby boomers and liberalized contribution limits had already opened the possibilities for small business owners, particularly those with five or fewer workers.
More significantly, while EGTRRA made modest increases in the limits for defined contribution programs, the enhancements for traditional pension defined benefit programs made these programs more attractive than ever.
According to Dorsa, the best candidates for these programs were firms:
- focused on benefiting the principal(s)
- where management/the principals were generally older than the rest of the staff
- where, as a rule of thumb, the principals were in their early 40s at least.
She noted that these type of programs were of particular interest to small employers since a “vast amount of the contribution goes to the principal.”
Small business owners tend not to save for retirement, tending to reinvest profits in the business and/or taking out profits in current compensation to the principal. Consequently, these entrepreneurs frequently have saved little or nothing for retirement.
As for the notion that defined benefit programs are more expensive, she noted that while “the hard costs are often higher with DB plans, the soft-dollar costs are much less. And you only need one person to have a DB plan,” she noted.
Even providers could find these small DB programs attractive, she maintained. For instance, while a five-participant 401(k) plan would generate neither the assets nor fees to be profitable for years (if ever), that same plan might quickly accumulate $200,000 in assets each year.
Small plan sponsors do evidence some consistent traits, according to Dorsa.
Most prefer to pay the costs of running the pension plan from corporate assets – taking the tax deduction rather than reducing the assets in the tax-deferred account.
She also noted that the rate of return estimates utilized in these programs tend to be lower in the smaller market, where plan sponsors tend to “dabble” more in making investment choices.
Another possible reason is that their smaller asset base sometimes precludes deploying a portfolio as diversified as larger plans. These programs also tend to self-trustee, she said.
Many of these businesses already have defined contribution programs, she noted, though their co-existence with the pension plan can limit the benefits of the latter. As a result, she frequently advises these clients to first terminate their DC plan and distribute the assets before starting up the DB program.