A common belief we hear in the business community is that the good old-fashioned defined benefit plan is disappearing-or gone. While this may be somewhat true for the large corporate plans, it’s hardly the case for small, privately held companies. A well-designed defined benefit plan is state-of-the-art tax and financial planning for the small-business owner and provides for other key benefits beyond immediate tax relief that often go overlooked.
Successful business owners are rightly concerned about growing their businesses. However, this singular focus on growing the business does carry’ some risk.
First, day-to-day effort of running a business often leaves little time for planning. Second, the success of the business may actually dissuade the owner from diversifying the source of wealth creation away from the business. A high asset concentration runs counter to modern portfolio theory’s prescription for diversification and exposes the owner to the real risks to business value, incuding dependence on a departing owner, technology changes, industry shifts, demographic changes, litigation and partner disputes.
We mention these because they can, and often do, arise at the most inappropriate times, more often when an owner is looking to liquidate.
Defined Contribution Plans
The solution to this vulnerability is preparation and planning. One of the most effective strategics to address this vulnerability is pension planning, and particularly the use of defined benefit pension plans. As mentioned, only a minority of owners sponsor a qualified plan, and of those who do, typically’ the choice is for some type of defined contribution plan, like a Simplified Employee Pension or 401(k) plan.
However, defined contribution plans have major drawbacks for the owners.
First, as measured by’ the percent of contribution going to principals, the plan typically will max out at 30 percent to 35 percent. That’s because, by’ nature, such plans are capped in absolute dollar terms and in relation to employee pay, which typically fixes heavy constraints on what the owners and other highly compensated employees can do.
Second, when measured against replacement of income, the 401 (k) plan because of these contribution constraints will typically’ only replace 10 percent to 20 percent of the owner’s income, even assuming a robust growth rate. Meanwhile, average employees, if they fully’ utilizes the plan, may see 30 percent to 50 percent of income replacement, much of that due to the contribution by’ the owner.
Neither of these aspects makes defined contribution plans appealing to the owners, so it’s no wonder many small firms go without.
Enter Defined Benefit Plans
The unique aspect of the defined benefit plan is that its stated objective is to replace income as defined by the benefit formula. The benefit formula typically centers on three key factors for replacing income: pay history, age and years of service.
Since many business owners tend to have a relatively high level of pay, many more years on the job and are often older than the non-highly compensated employees, the levels of contribution are typically many multiples higher than what a defined contribution plan can allow.
For the small-business owner, that translates into significantly higher tax deductible contributions, where commonly 85 percent to 95 percent is for the owner’s benefit. The effects of this on the owner’s financial position are manifold:
* Extended years of tax deferral;
* Diversification of the owner’s asset base;
* Protection from creditors; and
* Higher percentage of income replacement.
These are some of the core advantages of defined benefit, but in addition, they provide some intangible strategic advantages. To illustrate we can look at a common family business scenario.
For the business owner wanting to leave the business to family members, the defined benefit plan can create an asset base sufficient to replace a large portion of the income he is accustomed to, while leaving the business equity’ as a supplemental income source.
If the owner-parent has sufficient income from the plan assets, then the need to take cash flow from the company’ for his buyout payment is less pressing. This may mean the difference between sinking the business with a heavy monthly burden and allowing the successor owner-child some flexibility to manage cash flows in tough times.
In scenarios where the successor ownerchild proves to lack business acumen or potentially ruins the business, the ownerparent will have been insulated from the impact of mismanagement.
All too often we hear of family businesses practically driven into the ground as sons or daughters try to meet the demands of growing the business, while also paying an income to an aging parent. This risk is often painfully evident to both parent and child, and may lead the retiring owner to choose an outside sale, or the child to shun the opportunity to take over the business because of the perceived burdens.
This illustrates the need for careful succession planning and the important role the defined benefit plan has in making for a successful transition.
The common objections we hear about defined benefit plans are they are inflexible and place too much of a burden on the company. The reality of retirement income planning is that the owner needs to build up a store of financial assets separate from the business to generate his retirement income- unless of course he wants to gamble on an outright sale of the business at retirement.
But any business broker will tell you that most retiring owners quickly realize that while the business afforded a very nice lifestyle in the working years, the realistic sale price will typically come nowhere near to matching that.
The answer to the flexibility objection is in sound plan design, aggressive funding-especially in the early years- and understanding the options available to the owner should the business hit a rough patch. The plan design in most cases should concentrate on maximizing the percent of contributions going to owners.
Early overfunding of the defined benefit plan is a factor in the long-term health of the plan. Rules established under the Pension Protection Act of 2006 allow this overfunding to promote plan asset stability over the long run. By “overfunding,” we mean contributing more to the plan than would be required under the benefit formula.
The benefit of this is twofold: The ow ner gets a substantially higher initial tax deduction and the defined benefit plan now has some extra cushion to allow the owner to reduce future contributions should the business suffer a slowdown.
Finally there are some measures the owner can take should there be a prolonged period of business hardship:
* Freeze plan (halt future benefit accrual);
* Amend plan (i.e. lower future benefits);
* Convert plan to a defined contribution plan; or
* Terminate plan and roll out to IRA.
To varying degrees, each of these actions may reduce the cash flow burden on the company. Of course, the owner would want to avoid these actions if possible, but in certain cases w here circumstances demand it, it’s important to understand the flexibility a defined benefit plan offers.
Our opinion is that the defined benefit plan has become an overlooked, underutilized planning strategy to help small-business owners reduce their income tax, diversify their wealth, reduce dependence on business equity and replace business income for their future financial stability.
Like any good plan though, it requires time and commitment to make it successful. To a busy, overtaxed business owner, planning for a pension may be a challenge. But we might turn the logic around and ask, “How can you afford not to do some pension planning?” ®0
Daniel R. Bennett, M.S. Finance and Glen A. Michel, MBA, LUTCF are the managing directors of Advanced Pension Strategies. You can reach them at danielbennett@financialguide. com and firstname.lastname@example.org.