Is a Defined Benefit Pension Plan Right for your Business?

For business owners, there are many alternatives when it comes to establishing a retirement plan.  While 401(k) plans are a common choice that can enable contributions of up to $22,000 in 2010 (for those age 50 and over), what about those people who would like to make more sizable tax-deferred contributions into a retirement plan?  For these individuals, a Defined Benefit Pension Plan (DB) should definitely be considered.

A defined benefit pension plan is a qualified retirement plan whereby a specific annual pension payment is guaranteed to an employee or business owner at retirement.  While larger corporations have been phasing out pension plans recently, small or closely-held businesses can benefit immensely by establishing and funding these plans. 

Because funding requirements are based on a projected annual benefit level, deferrals into defined benefit plans can be quite substantial.  In fact, often times employers can make tax-deferred contributions in excess of $100,000 annually.  This high deferral level can enable those with defined benefit plans to create a substantial retirement fund in a relatively short period of time.

While any employer can establish a defined benefit plan, it is most suitable for businesses that have a small group of highly compensated owners and very few (or no) employees.  A DB plan is most advantageous for an employer who wants to maximize tax-deferred benefits and can afford to make large contributions.  Here are a few of the key strengths and tradeoffs when considering a defined benefit pension plan:

Strengths

• With less time until retirement, older participants are allowed to have greater contributions made on their behalf
• The plan is structured to provide a guaranteed pension benefit based on annual earnings levels
• Contributions are tax deductible to the business and investment earnings are tax deferred
• When the plan is suspended or terminated, the plan can be rolled into a 401(k) plan or an IRA

Tradeoffs

• The plan must be funded regardless of how the business is performing
• An actuary must be utilized to determine the annual contribution requirements
• DB plans are generally subject to ERISA rules and to "top-heavy" legal requirements
• The plan is not allowed to discriminate in favor of highly compensated employees
• Underfunding of the plan may require additional outlays of cash

While an actuary is required to determine the annual contribution amount, the formula is generally based on compensation, age, and length of service with the company.  The retirement benefit is calculated to be the lesser of $195,000 or the average of the three highest earning years.  As a result, if an employee is approaching retirement, the contribution levels could be significant.

While this type of plan sounds complicated and costly, there are companies that specialize in offering DB plans specifically for solo or small businesses.  If you are a business owner who would like the ability to increase your retirement savings, while simultaneously reducing your income tax liability, a defined benefit pension plan may be a suitable alternative.  If you have questions about your retirement savings strategy, or would like to explore the appropriateness of a defined benefit pension plan for you, please contact our office to schedule a meeting. 

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