What's Old is New Again
Every day, it seems as though another large employer is freezing or terminating its traditional pension plan-but, among smaller employers, these plans are enjoying a resurgence. In fact, smaller companies are using them as a wealth-planning strategy, and it looks as though they will continue to be used in the smaller arena, says Sarah Church, partner with law firm Thorp Reed & Armstrong in Pittsburgh, Pennsylvania. The growth in this market opens a significant door for advisers interested in serving the small- and micro-plan space, especially as many Baby Boomers start their own companies in retirement, explains Tom Foster, National Retirement Plans spokesman for The Hartford.
Today, advisers are successfully selling defined benefit plans as an alternative to the SEPs, SIMPLEs, and Individual 401(k) plans to small-business owners who are self-employed and have five or fewer employees. Thanks to the Pension Protection Act of 2006, which eliminated the sunset provisions of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), the richer benefits offered as part of that legislation will stay in place, which will add to the growth of the plans, Foster predicts.
Says Catherine White, assistant vice president with the Retirement Plans Group at OppenheimerFunds, “You read all about small-business owners who were focused on the business in [their] 30s and 40s and didn’t plan for retirement.” Those are the prime candidates for implementing a defined benefit plan, she says. While larger employers have demonstrated an interest in the ability of a defined contribution plan to shift investment risks from the employer to the employee, in a smaller company, the employer and employee are often one and the same, says Foster.
The small or solo defined benefit plans are appealing to those in a life segment where their housing is in good shape, their college saving needs are behind them, and who now are looking to ensure a comfortable retirement, Foster says. A defined benefit plan also can be used by a couple that may want to live off of one spouse’s income, while the other runs his or her own business. Since the defined benefit plan is based on the benefit to be received, having a shorter time period to make up for lost time doesn’t present the same issues as defined contribution plans, such as a 401(k) that imposes finite annual contribution limits.
The litmus test, notes Foster, for determining whether or not a defined benefit plan is a good fit consists of four things:
• Is the individual 45 years of age or older?
• Does the firm have five or fewer employees?
• Can the employer commit to making the necessary contributions for at least three years?
• Does the owner make more than $100,000 in annual earnings, or is his earning level significant enough that he can contribute more than the $44,000 annual contribution limit to a defined contribution plan under EGTRRA?
A defined benefit plan effectively allows a firm to fund an annual benefit in retirement of as much as $175,000, an amount subject to cost-of-living increases, White comments. To fund an annual benefit of $175,000 payable for life beginning at age 62, “using reasonable actuarial assumptions,” White says a participant would need to have saved approximately $2 million. Match that need against the circumstances of a small-business owner, who likely has been pouring all of his or her discretionary cash into the business-and then, at age 50, finally is getting to a financial position of being able to set aside money for retirement. Now try, under current maximum annual addition rules ($44,000 this year), to get to that $2 million with just a 401(k).
However, these pension programs can be relatively complicated to implement because the administration, filing, and funding formulas required are alien to most advisers. That is where a talented adviser can make all the difference.
Because of their smaller asset base, the investments used in such plans are generally retail class shares, which are more expensive than institutional shares.
An individual defined contribution plan also most likely would use such share classes, so the investments do not add much to the expense. Plan setup fees vary but consider that, for its “Solo db” plan, The Hartford charges a $1,200 base fee, plus an additional $50 per participant to establish the program. On an ongoing basis, there is a $1,500 annual administration fee plus $100 per participant, in addition to investment management charges. Other fees include: a takeover fee (if applicable) of $650, a $75 annual fee per account for participant rollovers, $100 per participant termination package, and participant loan fees of $100 up front plus an annual fee of $60.
Foster says that, although the contributions are based on actuarial assumptions about things like projected benefits, life expectancies, and interest rates, an adviser does not need to be an actuary to establish these programs. Since many providers currently offer turnkey solutions for defined benefit plans, the adviser merely needs to align himself with the plan provider.
White concurs that the providers, and their wholesalers, offer a great many resources to advisers to assist them in selling and servicing these plans. For example, she says, OppenheimerFunds’ Web site offers tools to assist advisers in prospecting and selling these plans to plan sponsors, including a tool that allows advisers to create personalized proposals online to take to their prospects. The site allows an adviser to plug in a prospect’s name, date of birth, company name, and information on as many as four other employees. The maximum contributions allowed to a defined benefit plan are then calculated, but an adviser also can specify how much a client wants to spend per year, and it will project the benefit. This report can be used to sell the plan, but it still requires an adviser to go back to the actuarial experts before implementing the plan, White explains.
Advisers then have to help the client set up trust accounts, although EMJAY Retirement Services, a company that administers the solo and small defined benefit plans offered by companies such as The Hartford and OppenheimerFunds, will assist them with things such as obtaining the employer ID number, among other things, White explains. Advisers also are responsible for offering support in selecting and monitoring the investments to be used in the trust fund, which will vary based on the proprietary fund requirements of the plan provider.
Overall, defined benefit plans for small-business owners represent a great opportunity for advisers going forward, Foster says.