While they were once a crucial element of the American retirement landscape, defined benefit plans – pension plans, in laymen’s terms – have fallen out of favor in recent years, having taken on negative connotations in the wake of the financial crisis. Fair or not, many people associate defined benefit plans with public sector employees, part of the broader wasteful and unwieldy apparatus of state and city governments.
Corporate pensions, for their part, are fast becoming obsolete as well. Most companies stopped offering them to new salaried workers long ago. And in an effort to shed fixed costs and stay competitive in still uneasy economic times, private sector firms are unlikely to start offering defined benefit plans again anytime soon, even if the economy begins to accelerate.
That said, defined benefit plans continue to make sense for at least one important demographic: Successful small business owners and entrepreneurs. For such individuals, pension plans are an ideal retirement vehicle, offering a wide range of benefits that will help them keep a larger share of their wealth and run better businesses.
But talk to any financial advisor and they will tell you that a surprising number of small business owners – even many high-net worth individuals – do not have any retirement plan in place, let alone a pension plan. That means no investments, no 401K or no IRA.
While that’s hard to believe for some people, on some level it is understandable. Given that most small business owners are extremely driven and tend to have a laser focus when it comes to building and growing their enterprises, they sometimes fail to dedicate enough time to their own personal financial affairs. And what often gets overlooked is coming up with a comprehensive personal financial plan that maximizes retirement savings.
For small business owners generating more than $200,000 a year in income, it is well worth thinking about setting up a pension plan – even if they already have existing retirement investments, including a 401K or an IRA or both.
For such individuals, the following are a few of the key benefits that pension plans have to offer:
*Higher contribution limits – Like 401K plans and IRAs, self-funded pension plan contributions are tax deferred for small business owners. (Employees cannot defer the contributions their employer makes for them). But unlike 401Ks and IRAs, pension plans have a greater level of flexibility and higher contribution limits.
By utilizing a pension plan to complement other retirement vehicles, small business owners can currently stow away more than $100,000 for retirement, which would allow them to pay taxes upon distribution, when their level of taxable income in retirement is likely to be much lower. With a 401K and an IRA, the typical small business owner can only defer less than a quarter of that amount.
*Employee retention – Following the financial crisis, employers of all size and scale cut employee benefits, and first on the chopping block in many cases were retirement benefits, including pensions and 401K plans. By making a pension plan part of every employee’s benefits package, small business can better retain their current workers, attract top outside talent and further set their business apart from other employers in their area – which will ultimately make them more competitive in the marketplace.
Frequently, small business owners can fund defined benefit plans on a profit sharing basis – incentivizing employees to maximize their productivity – and then offer such plans on a gradual vesting basis, typically over five years – thereby building a more stable and long-term workforce.
**Risk mitigation – Every small business owner or successful entrepreneur needs to take steps to protect against downside risk. One of the key benefits of a pension plan is that it is that creditors cannot seize its assets. Business owners are often the target of frivolous lawsuits, and though many have liability insurance and indemnification for protection, in some cases such protections are not enough.
By having a significant portion of their wealth tied up in a pension, business owners can give themselves additional diversification, and confidence, knowing that their retirement assets are not at risk, even in a worst-case scenario.
Small business owners considering setting up a pension plan for themselves and their employees should be aware that annual administration fees can sometimes be quite high, especially relative to other retirement plans. A plan actuary must calculate employee funding levels on a yearly basis, which is costly. Also, for those who need a high level of liquidity as working capital to keep their businesses running, pension plans may not always be the best option.
But for high-net worth business owners and successful entrepreneurs looking to take additional steps to protect themselves, their personal wealth and their businesses, all while maximizing tax advantaged retirement savings efforts, a pension plan can address all these objectives.