Why The Defined Benefit Plan Is the Single Most Powerful Investment Vehicle For Business Owners and Solo Entrepreneurs
Hey, what's up, everyone, Henry here, and today we're back to talk about Defined Benefit Plans and how they can benefit solo entrepreneurs and small business owners.
I want to start by introducing the defined benefit plan. Many of you probably are not fully aware of the defined benefit plan and how it works. If you are not, I don't blame you. The concept of the defined benefit plan is not new. It is often misunderstood, and most financial advisors don't understand it enough to utilize it as part of their plan. It's understandable because the defined benefit plan isn't for everyone. It does not work for individuals who are otherwise employed by someone else. However, if structured correctly, the defined benefit plan can allow small business owners and solo entrepreneurs to contribute even further towards their retirement and shelter more money from taxes. In fact, most of you have heard of defined benefit plans by its more common name; the pension plan.
History
Defined benefit plans, otherwise known as pension plans, has its roots dating back to 1778. At the time, the government offered retirement benefits to soldiers who were willing to enlist and serve through the entirety of the Revolutionary War. On May 15th of 1778, Congress passed a resolution providing all military officers half-pay and a set amount of $80 to all enlisted service members who remained in service to the end of the war. The pension benefits were made to encourage enlistment and to promote against deserters. On August 24th, 1780, Congress further expanded the benefits to widows and orphans of service members who perished in battle.
The first American defined benefit plan was created to encourage soldiers to enlist and stay through the Revolutionary War.
The exchange provided a level of guarantee that for many during that time was hard to come by. You have to remember, back in 1776, the American colonies were still in its infancy stage in comparison to countries across the world. The United States of America at that time is now what we call an emerging market! However, what Congress started at the time later was translated to private institutions because the certainty of a pension allowed for a semblance of normalcy in a continually evolving world.
It wasn't until 1875, a full 97 years later, that private corporations adopted the pension plan into the workplace. American Express created the first pension plan to provide benefits to elderly employees and those with disabilities. The idea was that in exchange for committing a length of service to American Express, employees would receive a percentage of their salary in retirement or upon disability.
This monetary incentive for staying with an employer for an extended duration showed that individuals were willing to commit their lives to a more significant cause. By 1926 there were over 200 pension plans offered in the United States. Following World War II, even more pension plans were created as companies raced to attract and retain a talented workforce.
The struggles that companies faced back then are very similar to the ones we face now. Finding talented employees and keeping them from being poached by a competitor was just as real back then as it is now. Pension usage allowed companies to benefit from such high appeal that individuals would spend their entire careers working for one employer. And it worked, because back then, it was not uncommon for a worker to start and end their career at the same place. This created an employee loyalty that is unheard of today. In contrast, the average employee tenure in 2016 was 4.6 years, according to the US Bureau of Labor Statistics.
As pension plans became richer and companies furthered benefits to maintain competitiveness, the actual underlying benefit became more embedded into an employee's retirement plan. When you pair pension plan benefits alongside Social Security benefits, individuals at the time really did not have to worry about outliving their money. They knew that guaranteed payments reflective of their earned income would continue to trickle in until their dying days upon retirement. Even after death, it would continue to pay out to the surviving widows.
In 1978, Congress passed into law Section 401(k), which brought the modern-day 401(k) retirement plan into our system. The idea was completely revolutionary at the time. In the differentiation of the pension plan funded by employers, retirement funding's responsibility was now shifted to the employees.
For corporations across America, this solved a myriad of financial problems that have been facing the pension plan system. You see, pension plans are not cheap to run. In fact, pension plans are enormously expensive when you try to maintain coverage for hundreds of thousands of former and future employees. As modern medicine increased our health and longevity, the financial burden of maintaining those payments became astronomical. The investments that supported the pension plan benefits also came under dire scrutiny as market volatility became increasingly common due to technology and trading volume. As pension plans faced an ever-increasing need to maintain steady cash flow to fund the annual income requirements, the risk exposure of the underlying investments decreased. But that became a catch-22 because as bond yields declined over the years, the investments' income kept coming up short.
In a way, the 401(k) was a saving grace and an out for companies struggling with the balancing act of pension plan benefits. As I mentioned, the shift placed the burden of retirement savings on the employees. As the 401(k) grew in popularity, the pension started fading away. In the current environment, pensions are primarily reserved for government employees, and approximately 10% of companies nationwide.
Why the Defined Benefit Plan Still Works In Modern time
Today, major corporations are no longer adopting the pension plans; they are instead trying to unwind it to no longer have to maintain it. Yet, we are seeing a resurgence of adoption for small business owners and sole entrepreneurs. You see, the reason why pension plans became unaffordable and costly was due to the number of bodies being covered. A Fortune 500 company employing hundreds of thousands of employees would find that it would cost millions of dollars annually to fund the necessary guaranteed benefits. However, small business owners and sole entrepreneurs are generally only trying to fund a minimal workforce. If you're a dental practice with less than 10 employees, you really only have to be concerned about funding for those ten employees. And as such, the budget becomes more manageable, the smaller the practice is. As a sole practicing physician, having a defined benefit plan means you're only trying to fund your own retirement, effectively making it a no-brainer.
So who is the defined benefit plan most ideal for? I said small business owners, but the term small business owner can be very vague. The company itself can encompass many employees. When I work with clients on establishing a defined benefit plan, a few criteria are critical to understand and consider. Business owners that are coming to me are generally wanting to structure a plan that allows them to maximize the most they can for their own retirement. Now don't get me wrong. More often than not, we have to provide benefits for the employees. Still, maximizing benefits for the business owner is critical. Business owners pour a lot of sweat, equity, and perhaps even blood into building a business. It's not uncommon for business owners to take a reduced salary and dump all profits back into the company to take it to the next level. In the early years, business owners are often not saving for retirement because everything else, inclusive of employees, is more important than themselves. When business owners are coming to me, they're typically in their late 30's or 40s and need to play catch up to ensure they are on track for retirement.
So going back to the criteria:
Employee count. A company with less than 10 employees is best. It can work just over that, but it can become very costly to fund when you start having 15 to 20 employees. Do I run into defined benefit plans for companies with employee counts in the 100 to 200 range? Yes, absolutely, but remember, the annual contribution amounts will need to pretty high, or the benefits per individual becomes relatively minuscule.
Employee age. Defined benefit plans are very age-based oriented. The business owner is generally the most senior in age when it comes to the business. When it comes to calculating maximum benefits, we incorporate period until retirement, which helps the business owner. Suppose the business also has employees that are close to retirement age. In that case, it can mean that the amount needed to fund the employees can be relatively high. A company with a young employee pool but very few individuals other than the business owner being close to retirement is best.
Existing 401k benefits. A company with existing 401k benefits like a 3 or 4% match and additional profit-sharing dramatically helps increase the amount that the business owner can put away towards a defined benefit plan.
And lastly, we like to see the need and desire to save more for individual retirement. This comes without saying that the defined benefit plan is most appropriate for the business owner, who is already maximizing his or her annual contribution limits to the 401k. For 2020, if you're already putting in the $19,500 or $26,000 if you're over age 50 and still paying a lot in terms of taxes, you will want to consider the defined benefit plan.
Pros
Of course, the primary benefit of the defined benefit plan is the additional contribution to retirement savings. For the year 2020, the 401k allows an individual to contribute $19,500 or $26,000 if over 50 towards retirement savings. Every dollar is saved from taxes.
There is no greater tax-deferred retirement savings vehicle has an upper limit of $230,000 annually. This high level of contribution amount is the quickest route to set aside retirement funds with maximum contributions allowing for over a million dollars saved in under five years.
If you are getting hammered on taxes, well, the defined benefit plan can allow for additional retirement savings. How much, you ask? Well, for a business owner, it can allow for up to 125% of annual salary during the first year. The ongoing contribution limit is the lesser of 100% of compensation or $230,000.
This high level of additional savings for retirement is apparent if your earnings are placing you in the tax bracket's upper levels.
The maximum limits to a defined benefit plan put the 401(k) plan in the little leagues from an upper limit comparison. At the core, there is no other vehicle out there for extremely high-income earners that would allow you to fund a million dollars towards retirement in under five years.
The contributions towards a defined benefit plan are tax-deductible. The investment earnings are tax-deferred, just like a traditional 401(k). It isn't until withdrawals in retirement that it becomes taxable as ordinary income.
Employees are also generally vested over a certain period. Suppose you are putting in benefits for an employee. In that case, they must continuously work for you over several years or forfeit the benefits. This increases retention and encourages productivity.
Cons
As stated earlier, the defined benefit plan is structured by an employer and funded only by the employer. Unlike the 401(k), your employees will never contribute to the plan, which places the burden primarily on the employer.
In today's modern times, I structure defined benefit plans in conjunction with existing 401k plans, eliminating the employer's total retirement savings burden. However, unless appropriately designed, the defined benefit plan will always include some benefits for the employees.
How much is that benefit? It depends on the employee's age count, as I mentioned earlier. It also depends on how great of an employer contribution you are providing on the 401k side. The greater the benefits you are providing on the 401k means we can offload some of the projected benefits you would normally incur on the defined benefit plan.
The defined benefit plan typically provides lifetime guaranteed payments for the plan's individuals, including the employees. Under a standard structure, you would have to maintain that plan for perpetuity until the last covered employee passes away. However, a modern plan structure can provide for a cash-out provision, which allows your employees to take their benefits with them if they are entirely vested. Additionally, you can also offload that perpetual payment to an insurance company by using annuity vehicles.
Like a 401k, a defined benefit plan requires prudent oversight of the underlying investments and the investment manager. The defined benefit plan should not be too aggressive or too conservative because it needs to encompass the needs of a varying age range of covered individuals.
Who the Defined Benefit Plan Is Most Ideal For
It's not uncommon for my defined benefit plan clients to be very similar in certain aspects because there is a maximization of benefits in play here. As I mentioned earlier, the defined benefit plan is ideal for the business owner who is already capped out of the 401(k) and wants to save more for retirement and shelter from taxes.
A defined benefit plan is prevalent for private health care practices like medical and dental offices. Law firms, accountancy firms, and consultants are also in this category. Real estate professional, beauty salons in general, family-owned grocery or convenience markets. Small service-oriented franchise. Landscaping companies and painting companies, etc.
As you can see, the actual categorization of service can be pretty broad. Still, the similarity is that most of the groups I mentioned are no more than 10 employees at the upper level. You also have the business owner as of the most senior in age, and most of the employees are younger in age.
Starting A Defined Benefit Plan
Structuring a defined benefit plan is relatively painless and easy. From a personal level, I always start with the conversation on understanding the individual and whether they need to save more on taxes and fund more towards their retirement.
Understanding what is already existing in terms of a 401(k) is essential. Reviewing what the employer contributions have been in the past helps fine-tune the business owner's benefits analysis.
Once we have the data analyzed, we can provide the business owner with a projection of what they can save in the DBP. We can also determine much of that is earmarked for the business owner and employees. At the end of the day, it's just a matter of deciding whether setting aside a few extra thousand dollars for your employees is worth it to save tens of thousands of dollars on personal tax liability.
Let's suppose the potential for retirement savings is high enough, and a sizeable amount can be set aside for the business owner. In that case, it's just a matter of establishing the account and going over the investment strategies.
The defined benefit plan provides a Solo 401(k) flexibility or a Traditional IRA in that the investment options are pretty unlimited. Just about every aspect of the investment world is open for selection, which differs from a corporate 401(k), which only allows investing under the set menu of funds. With the defined benefit plan, you can hold traditional stocks, bonds, mutual funds, and ETFs. Additionally, you can also incorporate private equity, closed-end funds, interval funds, and annuities. The defined benefit plan is flexible enough to hold real estate properties for investment purposes. This can be an excellent tax-efficient way to gain exposure to an important and sometimes overlooked asset class.
The defined benefit plan remains in existence over the business's life, allowing the business owner to continuously contribute. When the company is sold, and retirement income is the new financial concern, we send the employee portion of the funds to the employees and structure retirement payouts to the business owner.
Okay! Wow, I know we covered a lot, but in simplified terms, that is the structure of a defined benefit plan. At the very core, a defined benefit plan can be one of the most excellent tools a business can implement for retirement planning and employee wellness. You can save more on taxes, but you can provide more for your employees than just giving them a lump sum bonus.
Remember, financial incentives like a cash bonus may sound great. Still, when you factor in the taxes involved in giving a bonus, it really doesn't help your employees long-term when creating financial independence.
For example: Suppose you are providing a $2,000 bonus to an employee. The Social Security tax rate is 6.2%, which is $124. The Medicare tax of 1.45% is another $29. Federal income tax on supplemental income is 22%, which is another $440. That employee's net take-home on the bonus has now been decreased to $1,407. That's almost $600 given up to taxes, and that's not even taking into consideration applicable local state taxes.
Cash bonuses given can be eaten away by as much as 30% in taxes!
That $1,400 can disappear in the blink of an eye. Instead, you can create much more value and long-term effects by putting that $2,000 towards their future retirement and letting the power of compound interest take it to a whole another level.
And that's it for today, my friends. I hope you are all staying healthy, safe, and productive during these times. If you enjoyed the episode, please let me know. And additionally, I would love to hear from you if you are currently utilizing a defined benefit plan or have heard of it. I'd love to hear from the community how they have realized the benefits of this additional savings vehicle.