RSM Resources

Whether you are considering adopting a retirement plan for yourbusiness for the first time or evaluating an existing one, it’simportant that you understand your options. In general, two types oftax-deferred retirement plans are available: defined benefit anddefined contribution. Which is right for your midsized business?

Adefined-benefit plan, such as a traditional pension, promises eachparticipant specific monthly benefits during retirement. Aparticipant’s salary and length of service generally figure into thebenefit formula. In the private sector, employers generally fully funddefined-benefit plans, but most public-sector plans require employeecontributions. The employer makes all investment decisions.

Defined-contributionplans, such as a profit sharing plan and 401(k) plans — and 403(b)plans for tax-exempt employers — provide an individual account for eachparticipant. The benefits depend on the amount the participant and theemployer contributes, as well as investment income, expenses, gains andlosses.

In many defined-contribution plans, employees areresponsible for their own investment choices, and in 401(k) or 403(b)plans, employees are also responsible for their own contributionlevels. Employers may offer matching contributions in 401(k) or 403(b)plans; a common employer match is a 50 percent match on employeecontributions of up to 6 percent of pay. Employers may also providecontributions for all eligible employees, in addition to or instead ofmatching contributions.

Pensions: A thing of the past?

Traditionaldefined-benefit plans are about as common today as saddle shoes andhair tonic. But carefully implemented pension plans remain effectivetools for some businesses.

The shift in retirement funding todefined-contribution plans from defined-benefit plans has been underway since the 1980s. In more recent years, the combination of sustainedlow interest rates and a less-than-stellar stock market have doomedmany pension plans. The more poorly a pension fund performs, thegreater capital the plan sponsor needs to contribute to sustain thefund and meet its obligations to participants. Today, even many large,financially sound companies are either eliminating theirdefined-benefit plans, closing their plans to new entrants, or endingpension accruals for current and future employees.

Defined-benefitplans also have proved more complex and costly thandefined-contribution plans. In a typical example, shifting from adefined-benefit plan to a defined-contribution plan can reduce therequired employer contributions from 7 to 8 percent of payroll to 3percent of payroll for an employer profit-sharing or matchingcontribution.

Even though traditional pensions are waning, theyremain useful in some situations. Many owners of small and midsizedbusinesses and professional practices face a dilemma as they preparefor retirement. They must contribute enough funds to theirtax-qualified retirement plans to meet their own future needs, but thecost of contributions to cover other eligible employees can maketraditional defined-benefit plans unaffordable. Some find the answer byproviding the owner’s primary benefits through a defined-benefit planand providing other eligible employees’ primary benefits through adefined-contribution plan. Both plans are subject to nondiscriminationtesting.

Defined-contribution options

For mostemployees, a defined-contribution plan is likely to be a 401(k) planwith employer matching or profit-sharing contributions. Companiessometimes offer one or more varieties of defined-contribution plans,including money-purchase pension plans, profit-sharing plans without401(k) provisions, and employee stock ownership plans.

A401(k) plan allows employees to contribute pretax dollars throughregular payroll deductions. The employer may choose to make matching orprofit-sharing contributions, or both, on a tax-deductible basis.Investments can grow tax-deferred until withdrawal at retirement, whendistributions are taxed as ordinary income. Participants usually bearthe risk of choosing among various investments (such as stock and bondmutual funds) the plan makes available.

Some small-sizedemployers adopt simplified defined-contribution plans funded throughindividual retirement accounts (IRAs). These include simplifiedemployee pension plans (SEPs), which are similar to profit-sharingplans, and savings incentive match plans for employees (SIMPLEs), whichare similar to 401(k) plans.

With the SEP, the employer sets upan IRA for each eligible employee into which the employer makesdiscretionary contributions annually. Because employees have their ownindividual accounts, they bear the investment risk. This plan may beespecially suitable for new businesses or companies with cyclicalprofit histories, because the employer can vary the amount itcontributes from year to year — or even choose not to contribute inless profitable years. On the downside, employees cannot make pretaxcontributions to this type of plan.

A SIMPLE is an option forbusinesses with 100 or fewer employees that want to allow both employerand employee contributions. Employees can elect to contribute pretaxdollars through payroll deductions. The employer is required to providea specific matching or nonmatching contribution each year. SIMPLEstypically don’t carry the administrative costs and complexitiesassociated with 401(k) plans, but the limit on employee pretaxcontributions is lower than in a 401(k).

Not prepared to retire?

Manysmall to midsized companies struggle to provide even adequateretirement benefits. But offering competitive retirement benefits couldbecome increasingly important as workers assume more control over theirown retirement — that is, as they experience the absence of pensions,the threat of lower Social Security benefits, and more responsibilityfor contributing to their own retirement plans and managing theirinvestments.

A quarter of workers are "very confident" aboutretirement security, according to a recent survey conducted by theEmployee Benefit Research Institute. However, 22 percent of thoseworkers aren’t currently saving, and nearly 40 percent have less than$50,000 saved for retirement.

"The research shows that theoverwhelming reason companies don’t offer retirement plans to theiremployees is that they can’t afford to do so," says Steve Blakely,director of communications and managing editor for the Employee BenefitResearch Institute. "Also, if given an option, employees will choosehealth-care benefits in place of retirement benefits."

Nearly 45percent of households with working-age adults are at risk of beingunable to maintain their previous standard of living during retirement,according to a Boston College study cited in a recent Wall Street Journalreport. The article cites one financial planner’s analysis of debt andsavings ratios individuals should consider when figuring to generate 80percent to 85 percent of their preretirement income later in life,factoring in Social Security. A 45-year-old worker should haveaccumulated savings equal to about three times annual salary, overalldebt should be no more than one times salary, and a savings rate shouldequal 12 percent of income, according to the planner. A 30-year-old, bycontrast, should have 0.1 times salary saved, debt of no more than 1.7times salary, and a savings rate of 12 percent. The study uses asavings calculation that includes any contributions an employer makesto a retirement account, and debt includes home mortgages, which couldvary widely among markets.

Providing sufficient retirementincome for you and your employees at a reasonable cost to your businessrequires careful planning. Whether you want to establish a retirementplan for the first time or have your existing plan evaluated, aretirement plan consultant can help you evaluate the different types oftax-qualified plans available to your company. In addition, a financialprofessional can consult with you to help you identify the mostappropriate investment alternatives to offer within the retirement plan.

Defined-benefit plans

Advantages

• Guaranteed retirement income for employees
• No investment risk to participants
• Benefits at retirement not dependent on employee contributions

Disadvantages

• Potentially higher cost to plan sponsor
• Employer bears full liability for funding promised benefits
• Complex administrative and actuarial requirements

Defined-contribution plans

Advantages

• Potentially lower cost to plan sponsor
• Employees can choose participation level
• Participants can roll over savings to new employer’s plan or an IRA
• Participants can benefit from good investment results
• Tax-deferred retirement savings for employees

Disadvantages

• No guaranteed retirement income
• Participants bear investment risk
• Benefits at retirement dependent on employee contributions