A SURPRISING PROBLEM WITH DEFINED BENEFIT PENSION PLANS FOR SMALL BUSINESSES

Robert: Thank you for joining this edition of ‘Financial Transitions.’ Today’s topic is retirement planning – specifically, the defined benefit pension retirement plan. You may have heard of these as ‘pension plans.’ They were much more popular decades ago. Lots of large organizations and even government agencies had these pension plans. They provided a great source of retirement income for lots of folks. Unfortunately, nowadays, they’re quite rare. Most large companies don’t provide them anymore; they focus on the defined contribution plan, which is the 401(K).

Why have a defined benefit plan? You get to contribute a whole lot more to a defined benefit plan in each year than the alternative investment vehicles. For example, you can contribute $7,000 into your traditional or Roth IRA for 2019. Not bad, and that’s only if you are 50 years old – or older; if you’re under that, it’s only $6,000. So, $7,000 is okay, but it’s not great. If you step up a bit and have a 401(k) or something called a SEP IRA, you can contribute a lot more than $7,000; you can contribute upwards of about $50,000 a year, and for lots of small business owners, these are great vehicles. 401(k)s and SEP IRAs are simple, they’re cost effective and you get to contribute quite a bit of money; however, if you have a small business and you’re making a significant amount of income, where you could contribute – or you’d like to contribute – more than $50,000, then you need an alternative. That’s where the defined benefit pension plan comes in. I regularly see my clients contributing $200,000 or more per year into these plans.

Forget about an IRA or even a 401(k). These defined benefit plans are like retirement plans on steroids. You get to contribute a massive amount of money each and every year. So what’s the big deal? What’s the point? Why is it better to contribute so much more? One word, really: taxes.

Every dollar that you contribute to a defined benefit plan – or even a 401(k) – is a dollar that you’re not taxed on currently. If you’re in a high income tax bracket, for example, if you’re in California, New York or Illinois and are in the highest federal bracket, as well as the highest state bracket, you may be paying close to a 50% tax rate. Think about it. If you have $100,000 of net income, $50,000 of that is going to taxes. Instead, if you took that $100,000 and you put it into a defined benefit plan, guess what? None of that is taxed now. So, for a lot of high income business owners, they want to reduce their taxes. And so, these are amazing vehicles to be able to do that.

A defined benefit pension plan is great, but there are certain restrictions. Basically, I would only suggest a defined benefit plan if you’re 40 years old or over – and even 40 is a little young. The earliest I’ve seen anyone do this successfully is at 43 years old, and if you’re 45 or even 50, the numbers are even better.

It also is advantageous if you’re the only employee of your company (or maybe, you and your spouse). The numbers don’t work very well if you’ve got a company with a lot of employees. The problem is, you have to contribute not only to your own retirement plan, but there’s formulas where you have to contribute to your employees as well. If there’s enough income to go around and that’s something that you want to do, great, do it. However, for a lot of small business owners who only have independent contractors for example, or they’re their only employee, this is a great vehicle.

It also makes sense if you have a lot of excess income in the company. If you’re not making very much or you have losses, don’t even bother setting up a retirement account yet. You need excess money to be able to contribute to this.

So those are the advantages of a defined benefit pension plan. What are the problems?

A few months ago I wrote a ‘Forbes’ article, and I talked about both the advantages and the disadvantages to having a pension plan. The disadvantages really come down to fees, because you have to set the plan up, and the setup fee is typically $2,000-3,000. Then, each year, you have actuarial fees and administration fees, and those can be anywhere between $1,500 to $2,500 a year as well. But again, if you have a small company and you’re the only employee (or you and your spouse), and you have lots of excess income and you’re in a high tax bracket, it definitely makes sense to set one of these up, even knowing that you’re going to have to pay the setup fee and the annual fee. What you’ll save in taxes far exceeds what you’re going to be paying in fees.

There’s one more thing – and when I wrote the ‘Forbes’ article, I didn’t write about this.

Over the last three to four months, I’ve actually looked at and reviewed several defined benefit pension plan investment allocations. And, I’ve noticed something that I didn’t think was going to be a problem, didn’t think it was going to be a drawback, but what I’m finding is, it is. It’s a problem. So if you have a defined benefit plan, I would definitely pay attention here, because the ones I’ve seen have some problems.

Before I get into that, let me lead up to it by saying that most pension plans have thousands of employees as participants. Think about it. These pension plans traditionally were set up by really large corporations, like Ford or Disney, or large government organizations, like teachers associations or municipalities. These are investment plans, investment accounts, with literally thousands or hundreds of thousands of participants. What’s happened is that when these are invested, they have to invest them a little bit differently.

Imagine you have a company and you have 1,000 employees. Some of those employees are young, some are approaching retirement and some of them are already in retirement, yet this defined benefit pension plan has to meet the needs of all those people – the young ones, the ones about to retire and even the ones who are already retired. These are the folks where you’re actually paying them each month; the pension plan is having to pay out every month to those retired employees. So it poses a bit of a challenge, because not only do you have money coming out every single month, but you also have to invest it for the younger folks – the 24 year old. So how do you do that? How do you invest it for the young and the old at the same time?

Well, traditionally pension plans have been invested pretty conservatively. When I say conservatively, I’m talking about the allocation to stocks. So in the investment world, it’s really stocks, bonds, real estate and cash. Stocks are the providers of growth; they offer long-term investment returns. There’s also some volatility though, and there’s some risk in owning stocks. And because these pension plans are having to pay out the retired people, giving them their monthly benefit, pension plans are invested where most of the assets are in bonds and low volatility, pretty conservative investments.

In fact, there was a 2016 study by a pension firm where they analyzed thousands of pension plans. What they found was that whether it’s a small pension plan or a large pension plan, less than half of the portfolio was invested in stocks. So what does that mean? Well, it might not mean much, but it could be significant for you, and here’s why.

If you have a pension plan and it’s just you (or maybe, you and your spouse) and you’re 50 years old, do you think it’s an appropriate allocation for you to have 45% in stocks when you might be working another 15 or 20 years? It might be, but it probably isn’t. There’s a lot of research that shows that even as you approach retirement (or even if you’re in retirement), having a greater allocation in stocks is not such a bad thing. The problem is that if you have one of these pension plans and it’s just you (or maybe, you and your spouse), then there are teams of advisors out there – there are investment advisors, actuaries, administrators – who are focused on defined benefit pension plans. The problem is they’re used to working on pension plans with hundreds or thousands of employees. As a result, they don’t have a great deal of experience in working with single employee pension plans.

What I’ve seen over the last several months in reviewing some of these is that even for ‘younger’ pension plan employees (people who are 45 or 50 years old) who have years ahead of them, their allocations have been really conservative. I’m talking really conservative. The first time I saw it, I thought, well, maybe it was just the person’s risk tolerance, maybe they were super conservative and they didn’t want to take more risk. But when I talked to the individual, they said, no, my other investment accounts are 75% invested in stocks. So I thought, okay, well, maybe it’s not a risk tolerance thing, maybe it’s just a bad investment advisor or maybe it was the actuary or the administration firm – I don’t know, I figured it was just a fluke.

But after I looked at several others, and they were all invested somewhat similarly, I came to the conclusion (it might be accurate, it might not be), but what I think is going on is that the experts that are servicing these firms, the investment advisors that are working on these firms, are just so used to working on much larger plans that they’re just naturally conservative and they invest them too conservatively.

Here’s the takeaway: the first thing you should do is really calculate your allocation and your defined benefit pension plan. Figure out how much you have in stocks, bonds and cash. That’s really where you need to start, because that’s going to tell you a great deal. If you do that calculation and you find that you have 48% in stocks, ask yourself, is that appropriate? Does that make sense for you are, your retirement plan, when you think you’re going to retire? How does it compare to how your other accounts are invested? That would be a red flag, if you find that your defined benefit pension plan is quite conservative where your other accounts are not.

Let me tell you, the difference between a retirement account that’s 45% in stocks versus one that’s 65% in stocks over 10 or 15 or 20 years is significant. There’s a huge difference in investment returns.

It behooves you to figure out your allocation. If you find that it’s too low, I would definitely talk to the advisor who’s servicing that for you. Let them know that you think that it might be too conservative; tell them what your needs and goals are.

Also, consider finding a team of folks who specialize in pension plans, but more importantly, specialize in pension plans for small business owners, where they’re really focused just on working with people who are the only participant in the plan (or maybe, them and their spouse). That’s really where you want to be.

Also, I would look at the fees that you’re paying. There’s two types of fees: there’s the investment fees (that’s what you pay each year for the investments you hold) and there’s the investment management fees (that’s what you would pay to the advisor). On the investment fee side, I regularly see average investment fees exceeding 1%, and honestly, in my opinion, that is far too high. Your investment fees should be 0.5% or less. On most of the portfolios that I put together, the investment fees are about 0.3-0.25%, so that’s the range where you want to be. Also look at the investor advisory fee; you want that fee to be no more than 1%.

That’s basically the gist of this episode. If you don’t have a defined benefit plan and you think you might be a good candidate for one, check it out. You could save thousands of dollars in taxes every single year, and if you’re in a high income tax bracket, check it out. It might be one of the best decisions that you make. If you already have a defined benefit pension plan, I would definitely look at that allocation and make sure that you’re not under-allocated to stocks.

As always, if you have any questions, please feel free to reach out to us. The website address is https://www.pacificawealth.com/.

Thanks for listening.