Defined Benefit Plans (AllBusiness.com’s Chris Bjorklund interviews Lauren Okum of Pensions Specialists and Steve DuPuis of Black and Associates. 34 minutes)

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Chris Bjorklund: If you own a small business, you probably already know about some of the ways you can save taxes by setting up retirement accounts. But you might not have thought about creating a defined benefit plan. Steve Dupuis, a partner with Black and Associates is a specialist in defined benefit plans and investment strategies for private closely held businesses. We are also joined by another expert, Lauren Okum, director of Actuarial Services at Pension Specialists, a third party administrator for these plans. Lauren and Steve, welcome to the AllBusiness podcast.

Lauren Okum: Thank you, glad to be here.

Steve DuPuis: Thank you.

Chris Bjorklund: From what I’ve read about defined benefit plans, they have been around for years and in fact, they were very common years ago but fell out of favor. But now, aren’t you seeing a resurgence of interest in them, Lauren? And why is that?

Lauren Okum: Actually, they did fall out of favor and a lot of it had to do with the high cost of the plan as well as a more mobile workforce and the resurgence actually is due primarily to 2 things. First of all, many self-employed baby boomers are nearing retirement. They haven’t saved enough and it’s a good opportunity for them to save and back in 2002, the law changed that made it more advantageous for some of these small business owners to defer a large amount of money for retirement.

Chris Bjorklund: Steve, are you seeing that too?

Steve DuPuis: We have seen a resurgence in defined benefit plans but primarily in our practice, it’s the small closely-held businesses that are utilizing defined benefit plans. A small closely-held business with a predictable income stream and generally profits over and above salaries of the owners that would, you know, be in the 6- to 7-figure range. Those are candidates that we see that are appropriate.

Chris Bjorklund: What are some of the differences between a defined benefit plan and a defined contribution plan? I think a lot of people might mix up those terms.

Steve DuPuis: Sure, the defined contribution plan is what probably what most employees and employers think of these days as a 401K plan. Now, it can have a matching component where the employer puts money in. It can have a profit-sharing component where the employers put money in. But the critical issue is, that when the employee retires, the amount of money that he or she will have for retirement purposes is totally dependent on what those contributions have been along the way and how the investment performance has been along the way. So there’s no guarantee that there’s going to be a specific retirement benefit. That’s a defined contribution plan. There’s no guarantee what that benefit is going to be, you know, a monthly income of $5000, we don’t know.

Chris Bjorklund: All that’s defined is the contribution.

Steve DuPuis: Correct. In a defined benefit plan, that’s what we normally think of as the old style pension plan that, you know, GE would have had, that the most union plans have, still have to some degree, Exxon, a classic example locally or Chevron with pension plans, and in a defined benefit plan, you actually have a specific benefit that the employer agrees to pay to the employee on retirement. And that benefit is based usually on age, tenure with the company, last, you know, 3 to 5 year salary, that sort of thing. And it is completely funded by the employer and all the investment performance results are the responsibility of the employer. And if, at the end of the line, there is a shortfall in the funding for an employee’s retirement benefit, it’s the responsibility of the employer to make up that shortfall. So it’s a totally different kind of a plan.

Chris Bjorklund: You have anything to add there, Lauren, on that one?

Lauren Okum: Yeah, I think the main key too is that, in a defined contribution plan, the employee bears the investment risk.

Steve DuPuis: Right.

Lauren Okum: Whereas, in a defined benefit plan, the risk is borne by the employer.

Chris Bjorklund: That’s a big and important difference.

Lauren Okum: Right.

Chris Bjorklund: Specifically, we’ve touched on a few of the advantages of a defined benefit plan. Can you elaborate on some more of them, Steve?

Steve DuPuis: Sure, yeah. Well, of course, the greatest benefit in a defined benefit plan is that the employee doesn’t have to contribute any of his or her own money or the employee doesn’t. It’s the all the employer’s money that goes into the plan and you know, based on the plan document, there is a specified benefit that gets paid out on retirement. That’s a tremendous advantage to the employee, especially one who’s, you know, obviously some of these big corporations have paid out tremendous retirement benefits, I mean, the airline industry is a classic example. I would say, you know, that’s probably the primary benefit; however, these days if we are looking at a closely-held corporation, the owners have an opportunity by utilizing a defined benefit format, to defer 200%, 300%, 400% or more of the maximum defined contribution limit. So, you know, the limits in the defined benefit plan that an employer can get, you know, saving money for his own retirement, are phenomenal compared to defined contribution. So that could be a benefit today for a closely-held corporation owner.

Chris Bjorklund: And disadvantages? Lauren, do you know some of those? I mean, besides the complexity of trying to understand what a defined benefit plan is, are there other disadvantages?

Lauren Okum: Absolutely. Now, the huge advantage is the large contributions tax-deferred savings of a defined benefit plan but these contributions are not discretionary.

Steve DuPuis: Right.

Lauren Okum: You cannot choose every year what you’re going to make as the contribution. They may not be stable. They can fluctuate based on asset returns, demographic shifts, so you need to be prepared for a little instability there. And the plans must be set up as permanent plans. In order to be a qualified plan and get the tax benefit, the IRS deems them that they have to be permanent. That means, you have to keep them around. You can’t set it out for a year or 1 year of large contributions and then terminate the plan and not fund it. So, a general rule of thumb is 5 years so you’ll want to be able to keep the plan in place for 5 years and be able to make the minimum funding requirements for that plan.

Chris Bjorklund: You are talking about the, you know, permanent means may be 5 years? Is that what you’re saying or until you go out of business?

Steve DuPuis: Well, yes. You know, typically at least 5 years, the third party administrators are looking for these plans to be in place. Really, what Lauren is saying is that the employer has to be committed to this plan and whether or not there is a fluctuation, an economic fluctuation, for example in business income, the employer still has to make contributions for him or herself and all the employees that are covered under this plan. So it’s a big financial commitment. That’s why we say when we look for a candidate for a defined benefit plan, it’s a company that has a predictable earning stream over a long period of time. I mean, a doctor, a lawyer, a CPA, you know, these are the kind of candidates that we’re seeing that might be appropriate these days for defined benefit plans.

Chris Bjorklund: Well, yeah, you lead me to my next question which is…

Steve DuPuis: Who’s the candidate?

Chris Bjorklund: …the ideal candidate, you’ve touched on a few. Let’s talk about a concrete example, if you have one, some physician of one of these closely-held private businesses.

Steve DuPuis: Okay, sure.

Chris Bjorklund: Give us an example of how it might work for them in terms of setting up a defined benefit plan.

Steve DuPuis: Well, for many years actually, we have had an industrial client interestingly enough. Rubber and Plastics Manufacturing Company with 2 partners. The partners were when they first began this plan, probably 55 and 57 years old and their idea was they were going to work for a while, they’ve both come from very large rubber manufacturing corporations. They had a great background in the business in the industry, wonderful sales connections, and when they started this business, they were making tons of money. And the most important thing to them when they realized what their tax liability was to try and shelter some of this money. Now, they had about 10 employees running the firm. Obviously a small company but making probably a couple of million dollars’ net per year and we were able, over a very extended period of time, about 12, 13, 14 years, to put away in excess of 6 figures in the retirement plan for each one of these fellows. The only problems that occurred all the way along the line, I would say, were when business fluctuated, took a down turn, and they felt that they couldn’t fund to the maximum amount that they were supposed to. And that was an issue but at that particular point, the third party administrator stepped in and sort of changed the parameters of the plan. The estimations, the, you know, rate of return estimations in the portfolio and so on, and so forth and Lauren might talk to that because that’s a place where sometimes employers can get trouble. But these guys wound up, you know, basically retiring with several million dollars in this place. They never would have had that accumulation in a defined contribution type of plan.

Chris Bjorklund: And this is tax-free?

Steve DuPuis: Well, it’s been tax-deferred for many years…

Chris Bjorklund: Tax-deferred?

Steve DuPuis: …when they take it out and use it for living expenses and so on and so forth, then they will pay taxes on it.

Chris Bjorklund: So, the tax savings, do you try to give someone interested in a defined benefit plan, some idea of what their tax savings might be in a percentage that they would be saving? How does that work, Lauren?

Lauren Okum: Absolutely. The maximum contribution is really dictated by several factors, you know, including your current age, your retirement age, asset returns, and any other solutions that are deemed appropriate by your actuary. And so, when we look at a candidate for a defined benefit plan, picking a certain plan design will give them, based on their age, some estimates. And for example, at age 45 someone could likely contribute a $100,000. At a 35% tax rate, they’re saving $35,000. The older you get, the more you can contribute. For example, somebody age 55 could contribute around $165,000 which could give them a tax savings of, you know, over %60,000 and it just gets greater from there, all the way up to about $200,000 for somebody age 65, in their 60s.

Steve DuPuis: Yeah, our 2 partners in the manufacturing business put away in excess of $200,000 combined, between $200,000 and $300,000 a year between the 2 of them where they would have capped out at, well, at that the time that we put plan in place, probably, no more than $40,000 a piece. So it was very substantial in terms of how much they could shelter from taxation and how much they could shelter for retirement purposes.

Chris Bjorklund: So Steve, what impact does my age have on all these? I mean, let’s say, I’, within 10 years of retirement?

Steve DuPuis: Sure, 10 years, within 10 years of retirement is sort of an ideal time frame in which to start a defined benefit plan. Actually, the issue is that the closer you get to retirement, within certain limitations, the more money you can contribute to the plan because you have less time for that money to work, to build up a retirement fund so that you can use it in retirement. Generally, employers contribute much less money for younger employees even if they are highly compensated than they would for older employees. So a defined benefit plan really works better if a partner or an employee is older because they don’t have as many years until retirement.

Chris Bjorklund: You want to chime in, Lauren?

Lauren Okum: Sure, and if you think of this in dollar terms, right now, there is a maximum annual benefit that can be paid. And for 2007, that annual benefit is $180,000 a year. So if you look at paying $180,000 a year, that has an equivalent value at age 62 of about $2.1 million.

Chris Bjorklund: Oh, hello?!

Lauren Okum: (Laughter) That’s a lot! So if you think about, if you’re age 57, you have 5 years to fund $2.1 million; if you’re age 52, you have 10 years and I’m over simplifying but that’s where you can see how many years’ retirement can make a huge difference in the dollars that you need to contribute.

Steve DuPuis: That’s the leverage of a defined benefit plan.

Chris Bjorklund: Well let’s talk about the actual mechanics…

Steve DuPuis: Sure.

Chris Bjorklund: …of setting up a defined benefit plan. I’m assuming that you might start talking to your CPA or a financial adviser about that, is that step 1?

Steve DuPuis: Yes, typically that’s what happens. Usually, a financial adviser, certified financial planner, CPA, benefits broker, whoever it might be, registered investment adviser even who’s handling a different part of your portfolio, might sit down with an employer and take a look at their retirement program to determine whether or not the employer is maximizing his tax-deferred contributions to that sort of thing. Whether he is putting away enough for retirement and so forth. And that’s where the process starts. At that point, the financial services adviser usually says, “Well, Joe Employer, you know, let’s do a little bit of modeling for you, comparative analysis” and at that point, the financial adviser generally goes to the third party administrator. And with a defined benefit plan, obviously an actuary gets involved which is where Lauren comes in. And typically, what happens is that the actuary and the third party administrator model differ types of plans to determine exactly how much the employer can put away and defer from taxation and indeed, how much it is going to cost the employer in terms of employee contributions. So, generally then, when that cost analysis is done, the financial adviser comes back and shares that with the employer and the employer makes a decision on what type of plan to go with and if it’s a defined benefit plan, certainly at that point, the actuary and the third party administrator come in, write the plan document, develop a specific schedule based on the census numbers of the company. In other words, who the employees are, what their ages are, how long they have been working, how much money they’re making, and so forth. That’s where all of Lauren’s work comes in which is, it’s very significant, it’s very specific.

Chris Bjorklund: Before we get to the actuary, though, let’s say, I’m in a meeting with you…

Steve DuPuis: Sure.

Chris Bjorklund: …and we’re talking specifically about my company.

Steve DuPuis: Right.

Chris Bjorklund: Do you need my tax returns, do you need to know the number of employees and their years of service?

Steve DuPuis: Yes.

Chris Bjorklund: I mean, are we really getting into some nitty gritty detail?

Steve DuPuis: Yes, we are. At that point, in order to take that information to do an effective comparative analysis, we do need that information. We need census information which includes all of the employees in the company and particularly, of course, the partners or the senior execs of the corporation, how much money they are making, what their dates of birth are, how long they’ve been working for the company, all of that sort of thing is very important.

Chris Bjorklund: So if you come prepared to that meeting…

Steve DuPuis: Yes.

Chris Bjorklund: Then you could do this in a couple of hours?

Steve DuPuis: Well, you could certainly gather the information in a couple of hours. The comparative analysis that the third party administrator would do is more detailed than that. Typically, what’s going to happen I when that information is turned over to the third party administrator, the third party administrator is going to compare a defined contribution plan, a 401K with a say, a matching contribution, a profit-sharing contribution, then the defined benefit formula might come into play for comparison purposes. There are, I’m sure, Lauren will talk about this, but there are a variety of defined benefit approaches for an employer that might include the defined contribution plan and the rules and regulations are technical enough that it is possible for an employer to put away a great deal of money in a defined benefit program that might be only available for the top people and leave everybody else in the defined contribution scenario where the contributions to those rank-and-file employees might be fairly minimal.

Chris Bjorklund: And so then, when you step in, what do you generate for the employer? You’ve done this modeling, am I getting a printout or are we having several meetings, what do I have to do with you next?

Lauren Okum: Well generally I consult with the broker or the financial adviser to see what their goals are. Because as Steve mentioned, there are a variety of different plans that you can set up and where I would come into play is, you know, factor in a certain plan design based on their specific goals. For example, I have a lot of doctor’s scripts. There are a handful of doctors with several staff, generally where it works well, is the doctors are significantly older than the staff and we get into this lower offset design so basically, it’s the defined benefit plan is working in conjunction with the defined contribution plan and essentially, the doctors are benefiting from the defined benefit plan and the rest of the staff is benefiting from the defined contribution plan. So that’s the type of example that I might show to them, give them a printout, give them what essentially the contribution per person and I’[m hesitant per person because it is one employer contribution that goes into one trust but you can see generally how it is allocated to, you know, the principal group versus the staff. And so, we’ll give a printout of that and hand that over and see if that is an acceptable design and then I might toss them back and forth with some tweaking.

Chris Bjorklund: But always, there is sort of 3 of you working together, there’s the employer and your adviser and your third party administrator?

Steve DuPuis: Yes, usually that is the case and oftentimes the CPA is involved too. Because the CPA generally knows the employer’s tax situation more intimately than anybody else. Just to touch on what Lauren was saying. When we come back and sit down with the employer to actually lay out these proposals, the bottom line is the employer is looking at how much money he or she can defer into this plan. And if we say to the employer, based on Lauren’s modeling, we know that you can defer, you and your partner can defer $350,000 into this plan, the first thing the employer is gonna say ”Well, what’s it going to cost me?” And the answer generally is, “It’s going to cost you between, let’s say, 5% and 8% of payroll for the rank-and-file employees. And that is the critical formula usually that the employer wants to know because if he knows that he can put away several hundred thousand dollars a year between now and his retirement date and it’s only going to cost him $30,000 or $40,000 in contributions to employees, well, that’s a pretty significant tradeoff. You know, it’s a great benefit for employees certainly, especially when they’re younger but it’s just a tremendous benefit for the employer.

Chris Bjorklund: Speaking of the employer and the minimum funding requirements, that’s where, you know, I think they can beat that minimum funding requirement for the defined benefit plan. Lauren?

Lauren Okum: Now, if you can’t meet it and you know ahead of time that you might struggle meeting it, there are things that you can do in advance to lower the future benefits. Yet you can’t take away any benefit that has already been accrued but you can amend the plan. You don’t want to do it too often but if you know that you might be in trouble, you can amend the plan to reduce the cost. If you still can’t meet those requirements, there are penalties imposed by the IRS. There is definitely a 10% excise tax. So, not only are you going to be forced to make the contribution eventually, you’re also going to get taxed 10%. If the contribution is not made timely, they can tax you an additional 100% on the missed contributions.

Chris Bjorklund: Well that sounds like a lot of fees, yeah. Yes, we’re going down a very ugly road.

Lauren Okum: Right. Now, you can also apply for what’s called a funding waiver from the IRS which will reduce those taxes and it will allow you to pay that minimum funding requirement over a period of time. The IRS is selective about who they issue funding waivers so they have to meet, you know, certain criteria for the IRS to do this. The bottom line is you want to be able to pay.

Chris Bjorklund: Yeah, bottom line, come up with the minimum every year.

Lauren Okum: Right. Every year.

Chris Bjorklund: You’re listening to an AllBusiness podcast about defined benefit plans with experts Steve Dupuis and Lauren Okum. We’ll continue now with a question for Lauren about tax audits and defined benefit plans. Lauren, will setting up a defined benefit plan make it more likely that I’ll be audited?

Lauren Okum: I haven’t seen that in my experience. What I have seen in the past, and a few years ago, I think this was 2004, the IRS did have this focus audit program where they did target certain industries and certain plans. For example, companies in the healthcare industry or in the construction industry that had defined benefit plans that they targeted them. Likewise, in the manufacturing industry, if they had a profit-sharing plan or a money-purchase plan, those were the targets but in my experience, just setting up a defined benefit plan isn’t going to increase the likelihood of an audit.

Chris Bjorklund: I’m sure if there is an audit, though, the third party administrator somehow is involved?

Steve DuPuis: Actively involved.

Chris Bjorklund: Actively?

Lauren Okum: Oh, yes. (laughter)

Steve DuPuis: As a matter of fact, generally the third party administrator’s contractual agreement with the employer includes that sort of representation before the IRS. So that’s one of the things that an employer wants to check about their agreement with a third party administrator.

Chris Bjorklund: That’s a very good point and I’m glad we’ve talked about that. Now, do I have to have employees to set up one of these plans? Is there such a thing as a solo defined benefit plan?

Steve DuPuis: Well, there really is, you know, if you don’t have the employees, you don’t have any discrimination testing problems because, you know, you don’t have to make contributions for them. So, if we had a mom-and-pop, I don’t know, distribution company or sales company, something like that, a defined benefit plan could work very well in this situation where they were making substantial income and had been doing that for an extended period of time, yeah.

Chris Bjorklund: Lauren, have you seen a lot of solo plans? Solo defined benefit plans too?

Lauren Okum: I do see a lot of solo defined benefit plans and as Steve mentioned, they are actually a lot easier since you don’t have to worry about the employees and you can make the contribution or design the plan to get the highest contribution possible or to get the medium size contribution.

Chris Bjorklund: So it’s sweet.

Lauren Okum: It’s sweet.

Chris Bjorklund: What about loopholes regarding employees that are available to people that set up defined benefit plans? I’ve read something about part-time workers, people that were young, is there something there? Is there kind of, I don’t know if loophole is the right word, Steve?

Steve DuPuis: I think loophole is not really the right word. There are parameters that you can put in the plan document that can exclude certain classes of employees. This is true in defined contribution plans as well. It’s part of the overall tax law that applies to these plans. Lauren might be able to speak more distinctly on that.

Lauren Okum: That’s right. To the age sampling, you can exclude people under age 21 from participating in the plan and you can also exclude people with under a year of service. You could also do it under 2 years of service but then there are certain investing requirements as well. But generally, the rule of thumb is age 21 and 1 year of service. Now, you can’t specifically exclude a part-time employee or a seasonal employee. What you can do though is a year of service. What’s the definition of a year of service? A thousand hours. So if somebody does not meet that year of service requirement, the thousand hours, you can exclude them but you can’t exclude part-time or seasonal employees.

Chris Bjorklund: Well good. Now before we’re out of time, I definitely want to touch on getting money out of the defined benefit plan, how do you do that? What are the mechanics of that? And fees, we got to talk about that too. Who wants, Steve, you wanna jump in on how to get the money out? Why not?

Steve DuPuis: Sure, I mean, the best way to get the money is, of course, to retire; be older than age 59-and-a-half, and say “Well, I’m going into the sunset. I’m gonna take my boat off to South America or wherever I might be” and receive your pension distribution. You could take it out in a lump sum. You could have it paid out in an annuity. There are a variety of ways to take money out of the plan. But typically, it works the same way that we would think that it works if somebody retired from a large corporation, again like General Electric. They simply ride off into the sunset and the checks keep coming until they’re not living anymore. You know, hopefully, that’s what you want to see.

Chris Bjorklund: Let’s talk about fees.

Lauren Okum: Fees. A fee is good. Fees can vary significantly. It really depends on how you’re invested, are you actively managed? Are you in low cost funds and then you have the actuarial fees and the administration fees to take care of, all of the contribution requirements and the annual reporting information.

Steve DuPuis: Perhaps I can comment on that. You know, generally, the third party administration fees are fixed from year to year. There is a set amount that an employer pays out based on how much work the third party administrator does and usually, those fees don’t vary very much year in and year out.

Chris Bjorklund: Not a lot of surprises.

Steve DuPuis: No, no. There are not a lot of surprises. What Lauren is referring to really more than anything I think, is the investment management fees that are part of allocating these assets among different investment classes. And of course, most employers these days are used to using publicly traded mutual funds. There are mutual funds that are more expensive, there are less expensive oriented towards brokerage fees, or not oriented towards brokerage fees and quite frankly, our assessment is that the employer is best served by taking a look at a variety of plan choices. And because all of these investment advisers really fish out of the same pool, often the returns are very similar from one fund to another. And so, we believe from a brokerage point of view that the employer is best served by looking for low-cost fund opportunities. Obviously, in the past probably 15 or 20 years, index funds have gained a great deal of notoriety because they are low cost, they track the indexes by which most of these mutual funds are measured against and some people like John Vogel who started Vanguard Funds say, in the long run, investment advisers can’t beat the indexes. Quite frankly, some investment advisers do beat the indexes and it may be worthwhile to pay a little bit more in fees for that kind of rate of return, so…

Chris Bjorklund: Any last thoughts, Lauren, on let’s say, I’m going to ask my financial adviser about a defined benefit plan. What, you know, what should I be asking? What are the key questions I should ask for them to help them evaluate my situation?

Lauren Okum: Well, I think you really need to assess, given my age, my income, my age and demographic of employees, is this something I should consider? That’s the first question. Some advisers think defined benefit plans are great for anybody. They are not. You really have to meet certain criteria and a lot of it is age and income. And then, get a feel for how many years you will need to contribute and what is the bare minimum expected, you know a lot of things can change, but what is the bare minimum expected that I would have to contribute and can I contribute that for 5 or 10 years? And then, you’ll also want to talk with your financial adviser or broker about how to invest the assets.

Chris Bjorklund: So those are all good pieces of advice and Steve, you must want to add to that?

Steve DuPuis: Well, I would say, you know, the questions that an employer needs to ask are how much money can I put away and defer from taxation? How much is going to cost me in terms of contribution to employees to defer that money? And three, how much is it going to cost me in terms of on-going fees to operate this plan? How is it going to impact the bottom line of my budget? So, from an employer’s point of view, those are the key questions to have answered, I would say.

Chris Bjorklund: Well, thank you both for talking to us today.

Lauren Okum: Thank you.

Steve DuPuis: Thank you.

Chris Bjorklund: Lauren Okum with Pension Specialists and Steve DuPuis with Black and Associates, today’s experts on this AllBusiness podcast, explained how defined benefit plans work and the tax advantages for small business owners. Send your comments about this show or suggestions for future guests to podcasts@allbusiness.com. I’m Chris Bjorklund and thanks so much for listening.