Defined-benefit plans pay off for late starters - pension plans

Nation's Business, Dec, 1994 by Mary Rowland

Thanks to the red tape, high administrative costs, and snoopy Internal Revenue Service auditors, traditional pension plans--those that define the benefit that comes out of the plan at retirement--are going the way of the dinosaur, particularly for small businesses. But wait. There are still some perfect candidates for defined-benefit plans. If you are one of those candidates, no other retirement plan will suit you so well.

Answer these four questions:

* Are you over 50?

* Do you have very little in retirement savings?

* Is your business successful enough to make big contributions to a pension plan?

* Do you have only a few young employees or none at all?

If you answered yes to each, you would be allowed to put away more money for retirement under a defined-benefit plan than under any other type of plan.

"Defined-benefit plans still make a lot of sense," says Bill Mischell, a principal at Foster Higgins, a benefits-consulting company in Princeton, N.J. "The perfect candidate is a middle-aged professional with a much younger staff who is getting a late start on retirement planning."

Consider the doctor who recently sought pension advice from Laura Tarbox, a financial planner in Costa Mesa, Calif. He had spent most of his career as a general practitioner working at various hospitals before going back to school to specialize in obstetrics.

Now, at 51, with just $54,000 in a variety of pension plans and individual retirement accounts, he is starting his own practice in El Centro, Calif., with one employee. "Theoretically, he could put away all the money he will make in his first year in a defined-benefit plan," Tarbox said.

Tax-qualified pension plans--or those that qualify for a tax deduction for contributions made--are divided into two broad categories.

Defined-contribution plans are tax-free savings accounts, such as 401(k) plans. Federal regulations put a cap of 25 percent of the employee's pay or $30,000, whichever is less, on total contributions from the employer and the employee to a defined-contribution plan.

A defined-benefit plan, though, defines the annual benefit each employee receives at retirement, typically as a percentage of compensation. For example, the formula might provide for 1 percent or 2 percent of pay (up to the federal limit of $150,000) at the time of retirement multiplied by years of service.

The employer's annual contribution is then based on an actuarial formula that determines how much money must be accumulated to pay out that benefit. The formula takes into account the number of years before retirement and the amount of interest the money will earn--say, 8 percent a year.

An important advantage of the defined-benefit plan is that, unlike any other type of plan, it permits an employer to take into consideration prior years of service. "If you have owned your own company for 20 years, you can give yourself credit for those 20 years of service" when you set up your pension plan, says Jerry Carnegie, an actuary in the Rowayton, Conn., office of Hewitt Associates, an actuarial firm based in Lincolnshire, Ill.

Consider the example of a 50-year-old who started a company 10 years ago and has no retirement plan. If he chooses a defined-contribution plan, his only option is to begin retirement contributions this year up to the $30,000 maximum. But if he chooses a defined-benefit plan, he can look at his entire career with the company, set a retirement income goal that takes into account all of his years of service and his salary, and then calculate how much he needs to begin setting aside to meet the goal.

We'll assume that he will earn at least the maximum annual salary of $150,000 when he retires at age 65. If he uses the formula of 2 percent of pay, he would earn a pension of $75,000 a year. That would require a lump sum at age 65 of $750,000, according to Richard Joss, a resource actuary in the Seattle office of the Wyatt Co., an actuarial and consulting firm based in Washington, D.C. He uses "a factor of 10" in his calculations. To determine the lump sum needed to provide a benefit of $75,000 a year, he multiplies $75,000 by 10. The younger the business owner, the less he will need to contribute each year to reach that goal. But a 50-year-old must "get from zero to $750,000 in 15 years," Joss says. That would require a contribution of $35,000 a year, assuming an annual interest rate of 5 percent.

If he could afford to contribute more, he could raise the benefit formula from 2 percent of pay to give him the maximum allowed annual pension plan benefit, which is $118,800, an amount that is indexed for inflation. In this case, he could use 3.168 percent of annual pay to arrive at the maximum benefit. That means he would need a lump sum of $1.18 million upon retirement, raising his annual contribution to $55,000.

Even if you are an ideal candidate, though, you should consider the risks before setting up a defined-benefit plan. The IRS does take a hard look at small-business owners with these plans to see if they are using them to stuff away too much tax-free money rather than maintain a legitimate pension plan.