Q&A for the Small Business Owner

Why sponsor a defined benefit pension plan?
How does a defined benefit pension plan work?
Who is the best candidate for a defined benefit pension plan?
Does the plan cover other employees?
Is a defined benefit pension plan cost effective?
What factors affect the contribution to a defined benefit pension plan?
What are the risks of sponsoring a defined benefit pension plan? 
What plan design changes may be required? 
What are the potential pitfalls of a defined benefit pension plan?

Why sponsor a defined benefit pension plan?
Because of a number of recent changes in federal laws, the defined benefit pension plan has become an attractive way for a small business owner to build tax-deferred savings.

  • Small business owners over age 40 can contribute more to defined benefit plans than to 401(k)/profit sharing plans.
  • Small business owners can maximize tax-deferred savings by contributing to both types of plans.
  • Maximum annual contributions:

  • - Defined benefit pension plan: $50,000 - $170,000 (roughly)
    - 401(k)/profit sharing plan for 2007: $45,000 + $5,000 if age 50 or older

  • As with a 401(k) plan, benefits accumulate on a tax-deferred basis until they are paid at retirement, termination of employment or termination of the plan. Generally, benefits are paid in a lump sum distribution and may be rolled over to an IRA.

How does a defined benefit pension plan work?
In a 401(k) plan, contributions accumulate with interest in an individual account until retirement. In a defined benefit plan, however, there are no such individual accounts. The plan defines a monthly benefit beginning at retirement and payable for life. In practice, most participants choose to receive the lump sum present value of this monthly benefit. Taxes on this lump sum value can be further deferred by rolling the distribution over to an IRA.

Each year, an actuary determines the contribution to the plan to fund this "lump sum," based on assumptions regarding future experience. Differences between assumed and actual experience can cause plan contributions to fluctuate. For example, if actual investment earnings are greater than earnings assumed by the actuary, the contribution usually decreases. If actual earnings are less than assumed, the contribution usually increases.

Who is the best candidate for a defined benefit pension plan?

  • The small business owner who wants to maximize tax deferred savings
  • The small business owner whose future profits are expected to be sufficient to support a plan contribution of at least $50,000/year
  • Companies in which most employees are significantly younger than the owner.

Does the plan cover other employees?
Because the defined benefit pension plan must cover a nondiscriminatory group of employees and provide nondiscriminatory benefits, the plan must usually cover other employees. In a typical case, the other employees are significantly younger than the owner. Since benefit cost is much less for young employees, including these other employees is usually low cost.

Is a defined benefit pension plan cost effective?
In many cases, a defined benefit pension plan is a very cost-effective way to provide tax-deferred savings. However, because the plan is complex, plan expenses can be significant. Before a plan is adopted, an analysis should be made comparing the cost of the plan with the benefit of tax savings. The result depends on a number of factors: tax rates, years until retirement, and years before the benefits are taxed as distributions. Request a feasibility study.

What factors affect the contribution to a defined benefit pension plan?
Each year, an actuary determines the amount of contribution the sponsoring company should make to a trust fund so that all benefits are fully funded by the time benefit payments begin.

Plan contributions are calculated using a number of actuarial assumptions, which will not be precisely realized (e.g., employee pay, employee turnover, investment return on assets). Small differences between assumed and actual experience can cause significant changes in the plan's required contribution. For example, the following factors can increase contributions:

  • Lower investment return than assumed
  • Higher employee pay than assumed
  • Lower than assumed interest rates used to calculate lump sum distributions
  • Changes in federal requirements
  • Hiring new employees.

What are the risks of sponsoring a defined benefit pension plan? 
Generally, the small business owner should expect to maintain the plan for at least five years. Sponsoring a defined benefit pension plan is a long-term commitment to a financial liability and its related risks.

  • Increased contributions may be required due to unexpected plan experience or changes in federal requirements.
  • Some plan designs satisfy federal nondiscrimination requirements by taking into account substantial contributions being made for employees in the 401(k)/profit sharing plan. If those profit sharing contributions are not made, additional contributions to the defined benefit pension plan may be required.
  • Federal laws and regulations often change and require plan amendments and possibly plan design changes. These changes can increase plan expenses and company contributions.
  • Contributions to fund the owner's benefit are based on a target benefit commencement date. A significant change to the benefit commencement date significantly changes the funding goal and can create a funding surplus or deficit. When the plan is dissolved:

  • - Any funding surplus is subject to a substantial excise tax
    - Any funding deficit must be contributed immediately.

Careful coordination between the actuary and the small business owner ensures the plan is not overfunded or underfunded.

What plan design changes may be required? 
The typical plan design for a small business owner maximizes tax-deferred savings for the owner while minimizing the overall cost of the plan. This plan design must conform to federal laws that require plans to provide meaningful, nondiscriminatory benefits to a nondiscriminatory group of employees. A number of factors can affect plan design:

  • Pay levels and ages of future employees
  • When the owner will retire
  • Contribution levels to a 401(k)/profit sharing plan
  • How the IRS will treat a plan design feature involving legal issues not clearly addressed by the federal government
  • Federal laws and regulations.

Changes to any of the factors can require a change to the plan. Williams Actuarial Group can help with these issues by:

  • Creating realistic client expectations
  • Closely monitoring the factors affecting plan design
  • Proactively managing and communicating about potential changes.

What are the potential pitfalls of a defined benefit pension plan to a small business owner?

Restricted Lump Sum 
When the value of plan assets falls below 110% of current plan liabilities, the defined benefit pension plan (DB plan) is generally prohibited from paying lump sum benefits to certain highly paid employees. In most companies, and especially professional service firms, inability to pay lump sums when a partner leaves the firm is very undesirable. A number of steps can be taken to avoid this unfortunate situation or to minimize the disruption in benefit payments.

Excise Tax on Surplus Assets
When a small business owner retires, the DB plan is frequently terminated. Any plan assets left after paying benefits are generally subject to both ordinary income tax and a 50% excise tax. In other words, almost all surplus assets are paid to the IRS in the form of taxes ” a situation to be avoided! Careful planning with your actuary, especially close to retirement, can usually prevent this situation.

Double Taxation of Contributions 
For certain small business owners who sponsor both a DB plan and a profit sharing plan, the maximum tax-deductible contribution to both plans combined is the greater of 25% of compensation or the minimum required contribution to the DB plan. In practice, this combined plan limit is sometimes disregarded, and contributions are made that are not tax-deductible. The result is double taxation ” the owner pays taxes on the non-deductible contribution when it is paid to the plans and again when benefits are paid out of the plans. A well-defined contribution policy developed in conjunction with the plan's actuary can prevent this expensive mistake.

Gyrating Lump Sums
A small decrease in interest rate creates a large increase in the value of a lump sum benefit and vice versa. When a key owner is paid a lump sum benefit upon leaving the business, the key owner may have significantly under- or overfunded the benefit. Often such inequities in the DB plan can be minimized or even avoided. Solutions involve contribution adjustments, timing of benefit payments, and plan design techniques.

Volatile Contributions
Small business owners tend to prefer predictable plan contributions. Because of the nature of a DB plan, contributions fluctuate based on the experience of a number of variables, most importantly investment earnings. A number of planning tools can minimize volatility in contributions. They involve the choice of actuarial funding method, investments and plan design.