There are 23 million or so small businesses in the U.S., employing an estimated 50 million workers—and most of them don’t have a retirement plan in place. In fact, just 30% of small employers sponsor a pension plan, according to surveys from the National Federation of Independent Business.
But small-business owners ought to consider sponsoring such plans, according to the experts who participated in a MarketWatch panel discussion held in March in San Francisco.
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The type of plan or plans small-business owners sponsor will depend on several factors, according to Tim Kochis, the founder and president of Kochis Global; Frank Paré, the founder and president at PF Wealth Management Group; and Richard Stone, the founder and chairman of Private Ocean.
For instance, small-business owners must consider:
- The type of business they operate. Is it a small professional practice with a few highly compensated employees; or does it employ nearly 500 people, the upper limit of what’s considered a “small” business?
- The way their firm is organized as a business entity. Is it a limited liability corporation, a C corporation, an S corporation, a partnership or a sole proprietorship?
- The culture of the business. Is it a “lifestyle business” or one that has a plan to attract and retain top talent and grow?
“The options that people have are so different based upon what their business is,” said Stone. “Once you understand what type of business, it is then we can talk about what kind of plan might make sense.”
Type of business
According to The Tools & Techniques of Employee Benefit and Retirement Planning, a textbook used in financial-planning courses, there are more than a dozen types of retirement plans that small-business owners can choose from, including defined-benefit pension plans, cash-balance pension plans, money-purchase plans, profit-sharing plans, ESOP/stock bonus plans, savings/matching plans, 401(k) plans, cross-tested/age-weighted plans, Keogh plans, SIMPLE IRAs, Simplified Employee Pensions (SEP), tax-deferred annuities and non-qualified deferred-compensation plans.
Different types of businesses, of course, are best suited for different plans. For example, Stone said professionals and closely held businesses with highly compensated owners who are older than their employees, such as physicians, attorneys, accountants and the like, might benefit from choosing retirement plans that maximize the amount they can contribute for their own benefit. Those might include defined-benefit plans and cross-tested/age-weighted plans.
“One of the premier plans you would be looking at would be a defined-benefit plan because that is going to allow for the highest dollar amount to be contributed on behalf of the owners of the company and the highly compensated employees,” said Stone.
A defined-benefit plan is a qualified employer pension plan that guarantees a specified benefit at retirement. This sort of plan helps small-business owners—especially older, highly compensated ones—maximize tax-deferred retirement savings. With a defined benefit, the small-business owner uses one of several formulas to calculate how much income they will receive in retirement. Other types of plan professionals and closely held businesses might consider include money-purchase plans, target-benefit or age-weighted plans, cash-balance plans, or profit-sharing plans.
For his part, Kochis suggested that defined-benefit plans work best for businesses with just a handful of employees. “You have to provide the same kind of plan for all employees if it’s going to be a qualified plan, so this only really works for one- and two- or three-person shops,” Kochis said. “It certainly doesn’t work for organizations that have any number of low-level employees. It just would be uneconomical to do that.”
But a small business with hundreds of employees might consider sponsoring something other than defined benefit plan, said Stone. “They’re looking to offer something competitive to retain employees and keep their cost to a minimum, so they’re completely two different approaches,” said Stone.
Plans that fit this sort of profile include a 401(k), which is the most common type of plan sponsored by small businesses, according to the National Federation of Independent Business.
Caps on amounts in retirement plans
Stone said small-business owners who sponsor or plan to sponsor a retirement plan that lets them maximize their contribution should also watch efforts by the federal government to cap the amount of tax-deferred retirement contributions.
For instance, President Obama proposed as part of the fiscal year 2015 budget, as he did last year, a limit on the value of all tax deductions, defined-contribution exclusions and individual retirement account (IRA) deductions to 28% of income. What’s more, the budget also proposed an overall cap of how much money could be held in tax-deferred accounts, at an amount that would theoretically provide an annual retirement income of $205,000 using a formula based on interest rates, according to a PlanSponsor report. (At current rates, that amount would be about $3.4 million.)
“That’s shooting right at these types of plans that are designed to maximize the amount of contribution in the shortest period,” Stone said.
Other panelists, however, suggested that small-business owners need not worry about such proposals. “I wouldn’t give that piece of legislation much probability of actually being enacted,” said Kochis. “I don’t give this particular risk very much credibility.”
What’s more, Kochis said, small-business owners shouldn’t be dissuaded from putting in place such plans even if retirement-plan caps become the law of the land. “Even if it were the case, for very highly compensated small-business owners using a defined-benefit plan is probably still a very intelligent approach to take, because you can always scale it back if, in fact, you do encounter those limitations at some future point,” said Kochis.
Type of business entity
For his part, Paré noted that the type of business entity also plays a role in what type of retirement plan a small business might use. “Is it a corporation, sole proprietorship, or partnership, S corp versus C corp?” he said.
Pare noted that a C corporation is a separate entity in and of itself, while an S corporation is a pass-through entity. “Some of these [retirement] plans lose some of their attractiveness if it’s a pass-through entity,” he said. According to the IRS, for instance, distributions you receive as a shareholder of an S corporation do not constitute earned income for retirement-plan purposes. (See Internal Revenue Code sections 401(c)(1) and 1402(a)(2) ).
In addition, small-business owners must also consider the profitability of their firm and the stability of those profits. “We’ve got to look at whether or not they’re profitable today as well as into the future, and in addition to that, provide them with some flexibility so that if profits should fall—because we can never really depend on that or predict what the future holds—they have the flexibility to change up things,” said Paré. “Change maybe whether or not they’re putting money into their defined-benefit or defined-contribution plan…the business owner should maintain a level of flexibility into the future whenever they’re thinking of these types of retirement plans.”
Cost of retirement plans
The experts also said small-business owners ought not to fret about what they might perceive as the high costs of establishing and maintaining a retirement plan. “This is the good-news story,” said Kochis.
According to Kochis, retirement plans were expensive to establish and maintain 10 or 15 years ago. But that’s no longer the case today. “Large custodians offer small-business owners low-cost prototype plans,” he said. “These services are bundled internally in the plan and they’re very, very low cost.”
Kochis also said there is much more transparency with retirement plans for small business today. Owners can now evaluate administrative costs and investment transaction costs, for instance. “Some of the large mutual funds out there are offering very competitive plans,” he said, adding that the evolution of exchange-traded funds had also helped curb costs. “It’s pretty easy and pretty low-cost for an employer to offer a pretty respectable plan on behalf of the employees, using just a few low-cost vehicles inside.”
For his part, Stone suggested that small-business owners who consider offering a prototype 401(k) should keep two things in mind: First, that it should be a low-cost plan; and second, that if they don’t provide a match, they don’t have to worry as much about the firm’s current and future profitability.
“A 401(k) plan without a match doesn’t have that burden because individual employees are simply contributing from their own compensation,” said Stone.
Of course, small-business owners who have designs on being competitive with other businesses in their area or industry might need to offer an employer match. “Competitively they may want to do that…but they certainly aren’t required to do that and again it does protect them against the risk of reduced profitability at some point.” said Stone.
So, while many small-business owners might think that setting up retirement plan is costly, that’s not the case. “I think business owners…immediately think the cost is too high without necessarily understanding what’s involved in the process,” said Paré. “They may not even consider the tax savings that they might be able to realize from offering such a plan so I think a lot of it is just understanding what’s involved in the process and understanding the cost and realizing that it may not be as cost prohibitive as they may think.”
The culture of the business
Small-business owners with designs on sponsoring a retirement plan ought to consider the culture they are trying to create. “What is the culture of the business owner?” asked Stone. “What is that person trying to accomplish? I think that we can lose sight of the benefit that you’re going to get by setting up this plan—by having motivated employees that are going to contribute more to your top line—than worrying about these costs found in the bottom line.”
Stone gave this example: Small-business owners can control expenses by not offering an employer match. But that comes at a cost. “Because we are talking about small businesses we’re typically talking about the owner that’s receiving much higher compensation than the employees,” said Stone. “There comes a point in time in order for that owner to max out on the plan that they are going to have to pass what’s called a safe-harbor test to contribute more on behalf of their employees in order to fund themselves. At some point the math is very simple. It’s called the crossover point where it’s going to cost you more to include your employees in the benefits you’re receiving directly. That’s not the question. That’s not where you’re going on this.”
Instead, Stone said the question to answer is this: “What benefit will I derive from my workforce seeing that I’m making a sacrifice and contributing to them? I would argue strongly that you’ll see productivity go up and therefore lower the cost of your plan even though you’re contributing more money on behalf of your employees.”
Analyzing the MyRA
The experts also weighed in one President Obama’s plan to introduce what’s called the My Retirement Account, or MyRA, and whether it would be of interest to small-business owners.
In February, the president directed the Department of Treasury to create “myRA”—a simple, safe and affordable “starter” retirement-savings account that will be initially offered through employers and is designed to ultimately help low- and moderate-income Americans save for retirement. Presently, about one-half of working Americans don’t have an employer-sponsored retirement plan. (For more details, see the White House’s Opportunity for All: Securing a Dignified Retirement for All Americans and the Treasury Department’s myRA: A Simple, Safe, Affordable Retirement Savings Account .)
MyRAs will be Roth IRA accounts available to anyone who has an annual income of less than $129,000 a year for individuals and $191,000 for couples, according to Treasury officials. Initial investments could be as low as $25, and contributions as low as $5 could be made through payroll deductions, the White House said. Savers will earn interest at the same variable interest rate as the federal employees’ Thrift Savings Plan (TSP) Government Securities Investment Fund , or what many refer to as the G fund.
In the main, the panelists said small-business owners and their employees would be better served with plans that are already available, including and especially the 401(k) plan. The retirement plan for the masses already exists; it’s just that few business owners choose to put a 401(k) plan in place, citing cost and other reasons.
Among the problems with the myRA is the fact that the plan will only offer one type of investment. With a 401(k) plan, however, investors could have a number of investment options.
Still, Stone said small-business owners ought to consider including the myRA among their retirement plan options. “Oftentimes employees see these retirement plans as unaffordable for themselves,” said Stone. “In other words, they can’t afford to put away a little bit of something and so therefore they don’t necessarily participate. And I think that there is some responsibility that’s shared all around. [Employees] don’t have to necessarily become experts but they should at least learn that this is something that is for their benefit and just a little bit perhaps every pay period can be beneficial to them in the long run.”
Said Stone: “I think that’s what the myRA is really striving for. I wouldn’t throw it out. I would include it as another tool in the toolbox.”
And no matter whether small-business owners adopt the myRA or not, “I think maybe one of the benefits of this will be the rising awareness,” said Stone.