Are you being too generous?

Nation's Business, Dec, 1991 by Craid E. Aronoff, John L. Ward

When it comes to year-end contributions to employee profit-sharing or pension plans, many owners of family businesses are too generous.

Too often, the profit-sharing policy is more a reflection of the owner's personality than an objective decision related to business or family goals. The culture of paternalism, so common in family firms, further confounds the thinking.

Here's a typical story of a too-generous company:

In the early days, the Ajax firm had only a few employees. Pete, the owner, struggled to pay bills. He was grateful to employees who stuck with him. His moods varied directly with orders. When sales were up, he was up--and generous to a fault with pay raises and loyalty. But when sales softened and cash ran low, Pete would claw for survival. He hated laying off people, and it hurt him deeply when he had to ignore a hiring-anniversary date and the expected pay increase.

Pete knew he couldn't provide the same health insurance or perks of established companies. He felt he shortchanged his employees sometimes but that they accepted it out of loyalty. If an employee had a serious financial problem, Pete would find a way to help--perhaps a company loan or a job for a relative. That's what being a family business was all about, he reasoned.

Profits began to accumulate. Pete's tax accountant gave Pete the advice he offered all successful small-business owners: Set up a pension program based on a profit-sharing plan. Pete could shelter 15 percent of his own pay if he put aside an equivalent percentage for all other employees. In an era of high personal income tax rates, this seemed to make sense. Pete's accountant easily sold him on the idea, given Pete's paternalism and his sense of guilt about exploiting his employees.

The accountant made another attractive point: The plan was completely discretionary. If business went bad, there was no commitment to contribute.

Pete considered it the best possible solution to employee retirement needs--one that gave them a generous tax shelter too! Moreover, family successors would not be burdened by long-time employees' pensions.

But the program suffered in implementation. As soon as Ajax could afford it, Pete put aside the maximum 15 percent of payroll. In his exuberance to get started, he neglected to establish a formula for tying the amount of the contribution to company profits. For example, he could have limited the contribution to the profit-sharing plan to 25 percent of pretax profits, so that in good years, employees could actually count on a pension contribution matching 15 percent of their pay, while in bad years they would get less.

In fact, avoiding taxes motivated Pete more than providing an incentive for employees to be more profit-conscious. Even if he told them that their benefit was tied to profits, it would have meant little because he wouldn't tell them how much profit the company made. That secret could never be shared. If times were tough, wouldn't good employees leave? For a long time, Pete presented the company as less profitable than it really was, figuring it was safer.

In time, Pete discovered that he couldn't be discretionary even though the law allowed it. Even when business was off, he continued to make maximum contributions to the plan. "After all that these people have done over the difficult years, how can you cut their pension?" he reasoned.

As Pete's paternalism became ever more entrenched, his very generous 15 percent profit-sharing contribution became a permanent employee benefit rather than a discretionary tax shelter for the owner and his family.

As Ajax has grown and aged, competition and mature markets have made cost cutting essential. Pete feels burdened by the plan's high costs and now wishes it had been tied to actual profits. "Everyone would pull in the same direction if their reward really reflected profits," he says. But he's still unwilling to share numbers with employees.

"It's too late," he sighs. "After all these years, any cuts in the contribution will hurt morale."

But executive morale is already being affected. Long-term senior executives are nervously defending the status quo. Younger managers, especially Pete's children, are fighting for a more normal, just, and open system. The conflict is hurting the effort to achieve a smooth succession.

How do you avoid the trap that Pete fell into? There are no painless paths, only some tips:

* Help employees understand profit and industry realities. Employees will receive honest information as a good sign, not a bad one.

* Collect and share surveys on retirement plans of other companies in your industry and area.

* Establish a base level of contribution for retirement security, perhaps through a 401(k) plan.

* Base all other contributions on a formula driven by actual profits.

* Remember that the better you explain the concept of profit and the need for it, the more accepting and motivated employees will be. Consider an annual report to employees to help them understand company performance and how they contribute to and benefit from it.