So What if I Live Forever?
The radio blares out, “Miracle medical breakthrough! Live to be 150 years old,” and you think, now, that can’t be true?
Wait a minute! You may want to rethink your reaction. Every day we hear about more centenarians and it is a fact people are living a lot longer these days. On first blush, this sure sounds great, but consider one small item – lifestyle. What if you are 55 years old and expected to live to be 70 only to find out your new life expectancy is 100 years? You’d be in a world of hurt if you only have enough savings to last you until age 70, wouldn’t you?
You could commit suicide on the day you spend you’re last penny, but that’s not very practical. What would be better is if you had taken full advantage of the benefits of being in business for yourself and set up the most advantageous retirement plans available.
If you have employees, put yourself in their place. They will certainly need a vehicle for retirement savings. After all, they won’t have a business to sell as part of their retirement plan.
With that thought, welcome to this month’s column designed to help you maximize your profits by helping you keep your best employees. Last month, we suggested healthcare benefits as one way of encouraging employees to remain with you. While that will help your employees stay healthy, what good will it do them if they can’t enjoy that health in their golden years? Let’s face it, we may be living longer, but most of us haven’t taken the leap to wanting to work longer.
This month we will take a look at some retirement benefits you can offer your employees. Implementing one or several of these ideas will help you retain employees and make your life a little easier.
Because of the various requirements of the Internal Revenue Code and Department of Labor Rules and Regulations, as well as a great many creative investment advisors, there is a plethora of alternative retirement planning vehicles on the market. While we obviously can’t go into all the different plans, we can, and will talk about the broad types of plans, their benefits and their drawbacks.
Defined Benefit Plans
The first type of plan we will talk about is the defined benefit plan. A defined benefit plan is one where the plan expects to pay the employee a specified amount per month when the employee retires. In the alternative, the employee may choose to take a lump sum based on the present value of the benefits to be paid.
The benefits are generally computed based on a percentage of earnings. The three most common formulas used are the flat-benefit formula, the career-average formula or a final-pay formula.
The flat benefit formula generally pays a flat dollar benefit times the number of years service while both the career-average and final-pay formulas determine benefits based on the participant’s pay times the number of years service multiplied by a specified percentage of pay per year.
For example, say your employee, I. M. Through, retires after 40 years of service and her average salary has been $100,000 over her career. If your plan uses a flat benefit formula that pays $50 for each year of service, then her benefit each month will be $2,000 per month. If, on the other hand, you use a career-average formula that pays 1% for each year, the benefit would be $3,333.33 ($100,000 X 1% X 40 years divided by 12).
These type plans have the distinct advantage of allowing an employee, including an owner, to better plan any added retirement needs by giving the employee a more accurate idea of expected pension benefits. Defined benefit plans can be highly advantageous in situations where there is a small group of owners nearing retirement and a number of young employees. In certain situations, plans can be designed to help owners contribute more to retirement than they could have under a defined contribution plan.
However, the very thing that can make a defined benefit plan attractive can also make the plans highly unattractive. Because the plan will be required to pay certain stated benefits, it must be funded each year. Simply put, the longer an employee remains with the company, the more expensive it becomes to provide for the accrued benefits. If the payroll gets too high, and the employees remain with you, the cost of the plan may force you to terminate it.
In addition to the cost of providing benefits, you must use actuaries to determine required contributions and benefit payments if you have a defined benefit plan.
Defined Contribution Plans
To combat the negative aspects of the defined benefit plan, the defined contribution plan was established. In a defined contribution plan, the employer makes contributions, usually at its discretion, based on formulas contained within the plan documents. The final retirement benefit is based on the amount in the participant’s account at the time of retirement. There is no guaranteed benefit level.
One of the most popular types of plans in this category is a 401(k) plan. Many 401(k) plans are profit sharing plans that allow the employee to set aside part of their salary as a contribution to their own retirement. Any amounts taken out of the employee’s salary on a pre-tax basis is not subject to income tax until it is withdrawn. Some plans also allow after-tax contributions to be made. The employer may, at its discretion, match the employee’s contribution and also add profit sharing contributions.
Another type of defined contribution plan, the money-purchase pension plan, requires the employer to contribute a specified percentage of an employee’s pay to the plan each year. This type of plan, like the defined benefit plan, can become expensive depending on the employee base.
Other common variations of defined contribution plans include Employee Stock Ownership Plans (ESOPS), SIMPLE Plans, Keogh Plans, self-employed pension plans (SEP), stock bonus plans and thrift plans.
The primary advantage to these type of plans is the ability of the employer to better control annual expense. If the plan is properly designed, an employer may elect to forego payment of matching contributions and profit sharing contributions, while still providing employees with the ability to save for their own retirement using pre-tax dollars (401(k) plan). The only exception to this would be if the plan were considered top-heavy. In that instance, the employer would be required to make certain safe harbor contributions to avoid disqualification.
The primary disadvantage of defined contribution plans is the potential of limiting the amount of contributions you can make in a given year. However, by combining a defined benefit and defined contribution plan together, you can maximize pension plan contributions.
Other disadvantages of both type plans include administration costs, including reporting to employees, cost of valuing company stock in ESOP plans and costs of filing information returns with the Department of Labor each year. Except for SIMPLE and SEP plans most other plans will require annual reporting to employees and the Department of Labor.
Up until now, we have been discussing qualified plans. Simply put, when you have a qualified plan, the employer can deduct the expense for tax purposes (subject to certain limitations) and the employee does not have to pick the contributions up in income until it is received upon retirement.
There are, however, numerous non-qualified plans available. Most of these plans create a contractual liability on the part of the employer to pay an employee a specified benefit upon retirement. The estimated amount of the liability is then recorded as an expense each year for financial statement, but not income tax purposes. Many times, the employer will fund the expected liability by purchasing investments to meet the future obligation. As long as the assets remain in the control of the employer and are not transferred to the employee until retirement, the employee does not have taxable income and the employer does not have a tax deduction. When the benefits are paid to the employee, the employer gets an income tax deduction and the employee reports income.
While not as advantageous as the qualified plans, non-qualified plans can be very attractive because they do not have the same restrictions as qualified plans. Hence, an employer can provide the qualified plan benefits to key employees and also provide additional benefits through non-qualified plans.
The primary disadvantage to non-qualified plans is they are not deductible for tax purposes until paid to the employee. They also cannot be directly funded. This means the employee will always bear the risk of losing benefits due to adverse financial conditions of the employer. There are several techniques to help the employer invest so the future liability can be met. However, the investments will always be subject to the claims of creditors. Even with this disadvantage, the employee will have a level of comfort in knowing funds are available unless some catastrophic event occurs.
In this article, we have barely scratched the surface of the retirement plan options available to employers. One thing is clear, though – to find and retain good people, you have to offer more than a paycheck. Offering some form of retirement plan is an excellent way of attracting and retaining good employees.
Give us a call and let us assist you in evaluating the numerous retirement plan options available to you. Two heads are better than one and it’s our job to help you make the most of your opportunities. Let us do our job so yours can be easier and, who knows, if you build enough of a nest egg with good retirement planning, perhaps you will want to live forever.
Until we meet again in January, we want to take this opportunity to wish all of our friends the very best Holidays. Don’t forget to come back next month when we will finish our series on employee benefits with some other ideas that will be of help.