The defined benefit plan is becoming a little like the wild tiger — a little scary, possessing a certain elegant beauty, and possibly threatened with extinction. But ask someone who works with these plans, particularly in the smallest employer market, and you’ll find that (unlike the wild tiger) the defined benefit plan is thriving.
According to the Employee Benefit Research Institute, just 3% of private sector American workers participated in only a defined benefit pension plan in 2008, down from 28% in 1979. The reasons are many, ranging from fear of commitment to required contributions to a changing employer mindset. In 1978, Internal Revenue Code Section 401(k) was enacted, just at a time when a shift was taking place, away from the paternalism of past decades.
Employers jumped on the bandwagon of a plan with the rationale that employees are not children; treat them like adults and let them invest retirement money on their own. (This thinking extended to health care, too, but that’s a topic for another day).
According to Karen Shapiro, CEO of Dedicated Defined Benefits Services (www.dedicated-db.com), the defined benefit plan is alive and well — at least among professionals in private practice.
“These plans serve a specific purpose for a specific group of people,” she says. “These are often professionals who want to contribute as much as they can to a qualified plan in the last few years before they retire. In general, people who earn around $100,000 per year from their own business with five or fewer employees, as a professional, like a physician or an architect, or from a side business even if they are employed by someone else, can really benefit from a defined benefit plan. Not only can they add to their retirement, the plans also allow them to reap tax benefits for their business.”
While most people do not fall into the category of $100,000 or more earners with their own business, many do.
Shapiro says Dedicated Defined Benefit Service’s plan sponsors are often consultants, married business partners, medical professionals, and other high earners with a few lower paid employees. Sometimes, the client has been unable to contribute as much as he or she would like to their defined contribution plan.
“The internal revenue code allows for higher maximum contributions to a defined benefit plan, or a defined benefit plan plus a defined contribution plan, than for a defined contribution plan alone,” Shapiro says. With a defined benefit plan, plan sponsors may be able to contribute as much as $125,000 per year, for example, resulting in accumulations in the plan of possibly $1,000,000 to $2,000,000 in five to ten years.
Worries may be exaggerated
The term ‘defined benefit plan’ throws as much of a scare into some people as does the wild tiger mentioned earlier. Shapiro wants people to know that these plans don’t have to be scary. The main concern people have is that, once the plan is in place, they won’t be able to afford the required contributions in subsequent years.
“Even if their business is profitable to the point that they can make a large contribution to their retirement this year, sometimes business owners worry about profitability for next year,” she says.
That fear may be exaggerated. Yes, defined contribution plans, like profit sharing or 401(k) plans, do not necessarily require employers to make an annual contribution, and defined benefit plans do. But defined benefit plans do provide some flexibility, too. For example, as is the case with a defined contribution plan, defined benefit plans can pay out in the form of a lump sum distribution as well as in other forms of benefit, like installment payments.
PPA and good plan design alleviate required contribution fears
So that the plan doesn’t get caught short, the IRS provides guidance on how to fund defined benefit plans. The Pension Protection Act of 2006 allows flexibility in how much must be contributed each year, allowing for a range of contributions, Shapiro says.
“If a company owner establishes a brand new plan during the fourth quarter of the year, expecting significant profits and wanting to contribute as much as possible,” she says, “he may target putting $125,000 into the plan for that first year. Of course, he has little idea what his profits will be for the next year.
The Pension Protection Act changes mean that his actuary will calculate a minimum and a maximum contribution range for the second year, and the business owner is free to make a contribution of either, or any amount in between. In the plan’s second year, the minimum contribution might be $75,000 and the maximum $130,000. If the company has another great year, they might make the maximum contribution; if not, they could contribute toward the lower end of the range.”
“That’s part of good plan design,” Shapiro continues. “Using the right benefit formula and the right compensation history — even going back before the plan started — you can maximize the first year contribution, which maximizes tax savings. Then, in the following years, you have more flexibility in case the business doesn’t generate as much profit after that.”
There is even more flexibility when a defined benefit plan is paired with a 401(k) plan, Shapiro says. “A business owner can set up both types of plans. If there is a year in which their profits don’t allow the full contribution to both plans, they can make the minimum contribution to the defined benefit plan, and don’t fund the 401(k). Then the following year, if things have picked up again, they can go back to funding both plans.”
The Pension Protection Act also added a provision that allows any investment losses to be amortized over seven years. This allows some flexibility when the market takes a down turn, as it has in recent years.
Shapiro always reminds professionals (or their advisors) that contributions don’t need to be made until 8 ½ months after the end of the plan year, allowing time to put aside the money required.
Defined benefit plans remain viable even as they become more scarce. If your employees are already covered by one, congratulations. If not, it might be worth a second look; the benefits often outweigh the potential concerns.