The selection of a retirement plan is fraught with peril for the uninitiated. The myriad of plans (qualified plans, defined benefit plans, etc.) and the host of regulations which govern them is daunting even to the financial advisors that promote them to small business owners.
As a result of this maze, many financial advisors and business owners settle for “the plan in a box.” These retirement plans are referred to as prototype plans. The premise of the prototype plan is “one size fits all.” These plans are easy to understand, simple to administer and cheap. The word “cheap” reminds me of something my mother was fond of saying, “If it is too good to be true, it is!”
I would like to illustrate my mother’s observation on life with a husband and wife team which owns a small business. Gladys and George Madeit have owned their business for over 25 years. The children are through with school (private, college and graduate), the weddings are paid for and Gladys and George are finally able to “breathe.”
The Madeits have one full-time employee, age 27, Jane, and a part-time employee, Bob. After expenses are paid there is about $250,000 left to be allocated between wages and distributions for Gladys and George.
The Madeits approached our firm for a comprehensive business and financial plan. After a review of their documents, it was noted that their contributions to retirement plans was only $6,000. When we inquired as to why such a low amount was being contributed, they replied that “all that we are allowed to contribute is 3 percent of wages, $3,000 for each of us.”
After a review of their plan, we discovered that many years ago they had purchased a prototype profit sharing plan. It was a “safe harbor plan” with a mandatory 3 percent contribution for all employees. They were aware that they could put away more than 3 percent of their income; however, they did not want to contribute any more money to Jane, their full-time employee.
‘Safe harbor’ plan has drawbacks
They had purchased a profit sharing plan in a box. It was cheap, flexible (contributions only had to be substantial and reoccurring) and not mandatory. However, their choice had eliminated a 401-k provision and social security integration for their plan. These two additional options would have allowed them to contribute an additional $44,000 (2010 figures) and save $18,040 in income taxes (state and federal).
Additionally, because they had purchased a prototype plan, they were responsible for the annual plan updates, which had not been accomplished since 1991. The issues they faced were much more serious.
George had chosen to be the trustee for his plan, which is a fiduciary under the law. Because he and Gladys were close to retirement, he selected certificates of deposit as the only investment vehicle for the plan.
The Employee Retirement Income Securities Act imposes upon a fiduciary a duty to diversify plan investments “so as to minimize the risk of large losses…” Clearly they had run afoul of the act.
What they had purchased was too good to be true. They had been “penny wise and pound foolish.” Not only had they selected the wrong design for a retirement plan, they had chosen to take on responsibilities for which they were ill-prepared.
The universe of retirement plans is quite extensive. There are plans based on Individual Retirement Account (IRA) vehicles, plans which are qualified (defined benefit and defined contribution) and plans which are really not retirement plans at all, but are perceived by the public to be retirement plans.
Defined benefit plans
The first of the qualified plans is the defined benefit plan. This is the traditional retirement plan. If you work for an employer for a certain number of years, you are promised a benefit, a series of payments for life at retirement which represents a percentage of your pre-retirement earnings.