Retirement plans: simple is not always good

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.

Fiduciary responsibilities

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.

Such a plan is appropriate when the business owner is able to support a substantial tax deductible contribution over a period of years. A substantial contribution would be deposits in excess of $100,000 per year for the owner.

One type of defined benefit plan is a cash balance plan. While both defined benefit plans and cash balance plans are required to offer payment of an employee’s benefit in the form of a series of payments for life, defined benefit plans define an employee’s benefit as a series of monthly payments for life to begin at retirement. But cash balance plans define the benefit in terms of a stated account balance. These accounts are referred to as hypothetical accounts because they do not reflect actual contributions to an account or actual gains and losses allocatable to the account.

Both the defined benefit plan and the cash balance plan are insured by the Pension Benefit Guaranty Corporation (PBGC). PBGC insurance funds pay guaranteed benefits to employees whose employers are no longer able to support the promised benefits.

Defined contribution plans

Defined contribution plans do not offer “guaranteed check” at retirement. Rather, they allow for contributions into a “qualified plan” to provide benefits for employees at retirement. Additionally, defined contribution plans are not insured by the PBGC. There are many flavors of defined contribution plans.

One type, money purchase plans, mandates the employer make contributions on behalf of the employees each year. With a money purchase plan, the plan states the contribution percentage that is required. If the plan has a 5 percent contribution, then a deposit of 5 percent of each eligible employee’s pay is deposited into their separate account.

The participant’s benefit is based on the amount of contributions to their account and the gains or losses associated with the account at the time of retirement.

The key word for a money purchase plan is “mandatory.” Once a percentage is selected, it must be made. There is no flexibility as to the employer deposits. Therefore, this plan is not appropriate for a business in which cash flow is not predictable year to year.

Profit sharing plan

A profit-sharing plan allows for the flexibility that is lacking in a money purchase plan. With the profit-sharing plan, the employer decides how much to contribute (within limits) each year. Then, depending on the plan’s contribution formula, an allocation is made into the separate accounts of the eligible employees. The contributions only have to be “substantial and reoccurring.” It is possible that in some years a contribution is not made.

Often, a 401-k plan is attached to a profit-sharing plan. A 401-k allows for elective employee deferrals. It is the most popular type of retirement plan available today. The elective employee deferrals may or may not involve an employer matching contribution.

When there is a wide disparity in compensation, there is often a mandatory 3 percent matching contribution to all employees. This mandatory amount creates a “safe harbor” which allows highly compensated employees to maximize contributions without fear of a refund of excess contributions in the following year.

Since the elective deferrals are deferred wages, they are subject to social security, Medicare, and federal unemployment taxes.

In 2001, as a result of the Economic Growth and Tax Relief Reconciliation Act of 2001, the “Solo 401-k” plan was established for a self-employed individual or a business owner with no employees other than a spouse. Other names for the Solo 401-k are: individual 401-k, self-employed 401-k, or single participant 401-k.

Stock bonus plan

Another type of defined contribution plan is the stock bonus plan. It provides benefits similar to those of a profit-sharing plan, and like a profit sharing plan, mandatory contributions are not required. It provides benefits to employees in the form of shares of company stock instead of cash. It is a qualified plan in which distributions are usually made in stock of the employer, unless the employee elects otherwise.

Employee stock ownership plan

Finally, there are the employee stock ownership plans (ESOP). These are also qualified retirement plans based on a defined contribution. Like a stock bonus plan, the investments are primarily in employer stock.

The next set of retirement plans are not qualified plans. They are often mistaken for qualified plans and are lumped under the general heading of retirement plans. The vehicle is an IRA. The vesting is immediate, loans are not allowed, and life insurance is not an investment option.

The most basic of these is the payroll deducted IRA. The employer establishes the plan for the benefit of the employees. The number of employees covered and which employees are covered is purely discretionary. The yearly contribution limits are the same as for a traditional IRA: $5,000 maximum contribution and an additional $1,000 if the employee is age 50 or older.

Simplified employee pension

Next is the simplified employee pension (SEP). It looks very much like a profit sharing plan because it involves only employer contributions. This plan is not for employers with seasonal and part-time employees.

A SEP must cover all employees who are at least 21 years of age and have been employed three of the last five years with compensation of at least $550. Seasonal and part-time employees would place too great a burden on cash flow and profits.

The simple IRA was created to provide an inexpensive alternative to most retirement plans. And as such, any of the other plans are typically a better choice for the business owner.

There are mandatory employer contributions. There is a formula which must be adhered to in determining the employer’s contribution amount.

The vesting, because it is an IRA, is immediate. If the employee leaves at any time, the employer’s contributions to the employee’s account leave with the employee.

Another issue with simple IRA is the coordination with other plans. If a business has a simple plan, they may not integrate it with another retirement plan.

Now what about Gladys and George? We added a 401-k to their existing profit sharing plan and recovered the cost of the plan amendments through the reduction in their income taxes.