The Perfect Pension Plan For Small Businesses (June 2008)

Dominick Paoloni

According to the Employee Benefits Research Institute, the most popular plan choice for small firms with fewer the 100 employees is the 401(k). Of the small businesses studied, 58% offer a 401(k), 22% offer a SIMPLE IRA, 22% offer a profit sharing plan, and 13% offer a SEP IRA. However, are these the most effective plans for a small business? And is the best pension plan for a company made up of primarily lower-compensated employees the same for those with largely highly compensated employees?

Most small business start off with a SIMPLE IRA or a SEP (Self Employment Plan) IRA, which are very easy to put together, have no administration cost, and provide a level of deductions to the employer and employees. As the business grows the owners of a company, looking for greater tax deductions and opportunities for larger deferrals, usually move to a 401(k) structure which allows salary deferrals the Self Employment Plan does not (see fig.1)

	SEP-IRA	401(k)
W2 Salary	$100,000	$100,000
Owner Contribution	$25,000	$30,500
Salary Deferral	N/A	$15,500
Catch-Up	N/A	$5,000
TOTAL	$25,000	$51,000

While the 401(K) gives the employer greater deferrals, tax savings and ERISA liability protection, the plan maxes out the owner’s total contribution to $51,000 a year (if over age 50). As the owner’s compensation increases, the salary deferral is capped, leaving little relief from greater tax deductions on the increased salary.

The Hybrid Plan: Combining the 401(k) and the Defined Benefit Plan

The Defined Benefit- Defined Contribution Hybrid plan may be the answer to a company’s need for more flexibility and greater retention of key employees without the increased corporate cost of additional employee retirement compensation. Under the new Pension Protection Act of 2006, small business owners can continue their 401(k) to their employees but add a defined benefit for himself and his partners (with some restriction), increasing their deferrals by hundreds of thousands of dollars per year. A
simple example illustrates the advantages:

Surgical Practice:

Three partners: ages 62, 45, and 42
Three non-partners- physicians: early 30’s
One older business manager, two surgical assistants & two nurses.
Annual Payroll- $1.3 Mil

Existing SEP IRA: Partners get $45K each—a total of $135K out of the total contributions of $264K (51% of total contribution going to Partners)

By redesigning the pension the company was able to allocate funds based on the needs of the partners:

	Financial Goals	401(k)	DB/DC HYBRID
Partner 1	Maximum tax deduction	$51,000	$207,000
Partner 2	Higher tax deduction	$46,000	$100,000
Partner 3	Same tax deduction	$46,000	$46,000

Without significantly increasing the contributions to the non-partners:

Non-Partner Physicians- $3,600 each (total of $10,800)
Business Manager- $3,000
Staff (4)- $6,000 each (total of $24,000)

Result-Business objective met, Partners contribution— total of $352,000 out of the total contributions of $389,800 (91% of total contribution going to Partners)

In the above example, working within the current pension laws, the partners set up a Defined Benefits plan, keeping the employees enrolled in a Defined Contribution (401(k)) plan. This structure allowed the company to dramatically increase the deferral limits which gave the corporation, as well as the partners, substantial tax savings. In addition to the tax savings, the total retirement package is skewed 91% to the partners as opposed to only 51% to the partners under the SEP. The company paid out only $62K to employees with the Hybrid DB/DC combination while it cost the owners more than double in employee benefits, $129K with just the SEP.

The hybrid plan allows the partners the flexibility, within plan limits, to elect which employees to place in the DB plan and which employees are placed in the DC plan.

According to Benefits Quarterly a Defined Benefit option for key employees has a powerful effect on attracting and retaining key employees.

Hybrid plans should only be considered by established companies that have a consistent cash flow. When a DB component is put into place the company is incurring a degree of risk in that the funding stream should be maintained for at least 3 years. The company needs to stand short-term funding requirements in exchanged for the longer term benefit of lower expected cost and employee retirement goals.