"Set up a 401(k) for me." That's the first thing most small-business owners say to Jim Rafoth when he talks to them about establishing a pension plan. Yet a 401(k) is not what most of them get. Rafoth, a broker with Beard Pension Services in Youngstown, Ohio, has built about 300 pension plans for small businesses. Only 80 are 401(k)s.
Even though 401(k)s are a cornerstone of brokers' retirement plan business, other plans prove a better fit for small-business owners, according to Russ Alan Prince, a marketing consultant in Stratford, Conn. "A 401(k) is top-heavy, a lot of participation is needed and there are limits on what an owner can put in," he says. Early this year, Prince studied qualified plan usage among small-business owners in a survey. He found that business owners often don't know they have options other than 401(k)s.
The menu of alternatives for small businesses has grown richer in recent years. Owners can choose the low-cost, low-maintenance Simplified Employee Pension (SEP) plan or a Savings Incentive Match Plan for Employees (SIMPLE). In the qualified plan area, profit-sharing plans now offer sophisticated options to maximize an owner's contribution. In addition, money purchase plans give owners close control of what goes into a plan and who participates. Brokers are even finding that defined benefit plans are a solution for certain older small-business owners (see "Defined Benefit Plans Regain Some Popularity").
Offering SEPs and SIMPLEsA SEP is an entry-level pension plan. "It's best for start-up companies that don't know what their profitability will be," says Joseph Balestra, regional pension consultant with Benetech, a small-business retirement plan consultant and plan administrator in Chicago. Owners can decide each year whether to make a contribution and don't have to make any federal filings. They can contribute up to 15% of an employee's salary or $30,000, whichever is less. For self-employed people, though, contributions effectively are only 13%.
Employees can't contribute to a SEP. And owners can't be selective about who they cover. Eligibility requirements are broad. Owners must also be comfortable with immediate vesting in such plans.
The SIMPLE debuted in January 1997 as a replacement for the Salary Reduction Simplified Employee Pension (SARSEP). "The SIMPLE is really a 'super IRA,'" says Mark Aho, a Salomon Smith Barney broker in Marquette, Mich. "You put $6,000 a year in and can still put money in an IRA."
Available only to businesses with fewer than 100 employees, the plan allows employee contributions. Owners must match dollar for dollar up to 3% of pay for those who participate. The plan isn't tested for participation.
"I see grocery stores with 50 to 65 employees, very few full time, who have had a 401(k) plan with red-tape problems," Aho says. "The SIMPLE works nicely for them. Every time an employee makes a contribution, he gets a statement. There's no vesting and it's easy to set up."
Family businesses also often find a SIMPLE attractive. "Owners can double the $6,000 contribution limit if their spouses work in the business," Rafoth says. The rules allow the spouse to make a $6,000 maximum contribution without running into restrictions.
Choosing Profit-Sharing PlansProfit-sharing plans are the next item on the small-business owner's retirement plan menu. As qualified plans, they require compliance with ERISA regulations. Profit-sharing plans offer owners a lot of control. Owners make the contributions and can change them annually. Contributions are a maximum of 15% of net eligible payroll up to $160,000, indexed by the cost of living. The individual limit is $24,000. Owners can customize eligibility and set up a vesting schedule--important for small businesses with high employee turnover.
David Schwarz, a Prudential Securities broker in Worthington, Ohio, uses what he calls a "$50,000 litmus test" to determine when a profit-sharing plan sh ould be considered instead of a SIMPLE. "In a profit-sharing plan, an owner making $50,000 in taxable wages could only contribute $7,500, but in the SIMPLE, he could do $6,000 plus 3% of salary, which would be the same," Schwarz says. "If an owner is over the $50,000, then looking into profit-sharing plan structures is best."
But the move to qualified plans means more paperwork and higher costs. "Owners can expect a straight profit-sharing plan to have an annual cost of $750 plus $30 per participant," Balestra says. Brokers can keep costs down by using a turnkey provider that both establishes and administers the profit-sharing plan, Aho says. "The higher cost works out when I can show how the employer can put away $30,000 a year in the plan."
Reaching the $30,000 contribution limit allowed in qualified plan regulations requires pairing a profit-sharing plan with another type of qualified plan, the money purchase plan, Rafoth says. With a money purchase plan, an owner makes a mandatory annual contribution as high as 25% of net eligible payroll up to $160,000, indexed by the cost of living. The individual limit is the lesser of 25% or $30,000.
To create a paired plan, an owner typically agrees to a 10% mandatory contribution through a money purchase plan and a discretionary 15% through a profit-sharing plan, Rafoth says. This allows an owner to maximize contributions in good years and scale back in lean years.
Profit-sharing plans also allow owners to favor themselves and key employees. A cross-tested (or comparability) profit-sharing plan bases contributions on demographic characteristics of employees, complying with discrimination testing regulations. The owner divides employees into certain groups, such as by age (an age-weighted plan) to direct a greater share of company contributions to key employees.
"A cross-tested profit-sharing plan gives the best of a defined-benefit and defined-contribution world," Prince says. "An employer can selectively reward. If the owners are older than employees, an age-weighted, cross-tested plan allows them to put more money away for themselves."
Cross-testing enables an owner to make sure that one or two much older employees don't increase the contribution limit for all employees, says Mark Smith of M.J. Smith & Associates/ Raymond James Financial Services in Aurora, Colo. "With cross-testing, that older employee gets lumped in with the younger employees."
Rafoth says cross-tested plans work best with companies establishing a new plan. "If you replace a plan, employees typically end up getting significantly less," he says. "We've had a couple of clients where we replaced [with a cross-tested plan] and they came back saying they couldn't do it because their employees were upset."
The tiered profit-sharing plan is a less-known option. It's structured to favor owners and key employees by putting owners and employees in as many as four categories: owners, family, managers and all other employees. Each category can then be tiered according to age. "About 95% of the time if an age-weighted plan works, then a tiered plan will work better," Balestra says.
A tiered plan works best for companies with no more than 30 employees, in which the owner is older than the majority of plan participants and key employees' salaries are higher than other employees'. "Owner contributions can be as high as $30,000, or 25% of compensation, each year per owner," Balestra says. "You can get the owner's portion to be 70% or 80% of the money that goes into the plan," he says.
Knowing the ClientFinding the right plan for a client means knowing what the owner is trying to accomplish. "They don't know much about pension plans, but they know whether they want to help employees or not," Smith says.
Take time to understand a client's business, Schwarz advises. What form of business organization does the company have? What's the profit picture? How many employees are there? How old are they? What are employee turnover patterns? Are there any unions?
"You must climb inside the payroll," Schwarz says. Determine how the owner is compensated. "Just because he earns $100,000 doesn't mean he can use $100,000 to determine the retirement plan contribution," he says. "The owner may take salary plus an end of the year bonus, or salary plus an end of the year dividend. There are a lot of things CPAs have done to help the owner's money with taxes."
Reps who understand and can offer plans other than 401(k)s will have productive relationships with small-business owners. Concludes Prince, "If you don't know the alternatives out there, you effectively end up saying, 'I'm not going to be in the small-business market.'"
Simplified Employee Pension (SEP)
Owners Who Can Provide This Option: Any business or self-employed individual.
Plan Contribution Limits: Owner can contribute up to 15% of an employee's salary or $30,000, whichever is less.
Funding Responsibility: Owner contributions only.
Employee Eligibility: All employees at least 21 years old, employed by the business for three of the past five years and earning at least $400 in a year.
Vesting: Immediate 100%.
Key Advantage: Contributions don't have to be made every year. Easy and inexpensive to establish and administer.
Key Disadvantage: Must cover all eligible employees. Employees cannot contribute.
Savings Incentive Match Plan for Employees (SIMPLE)
Owners Who Can Provide This Option: Any business with 100 or fewer employees that doesn't have any other retirement plan.
Plan Contribution Limits: Owners must match dollar for dollar up to 3% of pay for those who participate, with a maximum of $6,000. Contributions can be lowered to 1% in two out of five years. Owners can also choose a 2% across-the-board contribution (up to $3,200) to all eligible employees, regardless of participation. Employees can contribute 100% of pay up to $6,000.
Funding Responsibility: Employee contributions and owner contributions.
Employee Eligibility: Must be offered to all employees who have earned at least $5,000 in either of the past two years and who will earn at least $5,000 in the current year.
Vesting: Immediate 100%.
Key Advantage: Employees can contribute.
Key Disadvantage: Matching contributions by owner are mandatory.
Profit-Sharing Plan
Owners Who Can Provide This Option: Any business or self-employed individual.
Plan Contribution Limits: Maximum of 15% of net eligible payroll up to $160,000, indexed by cost of living. The individual limit is $24,000.
Funding Responsibility: Owner contributions only.
Employee Eligibility: Must be offered to all employees at least 21 years old who worked at least 1,000 hours in the prior year, two years if no vesting period.
Vesting: Determined by owner.
Key Advantage: Contributions can vary from year to year. Owner can adjust contribution allocation--age-weighted, Social Security integration or comparability (tiering).
Key Disadvantage: Employees cannot contribute.
Money Purchase Plan
Owners Who Can Provide This Option: Any business or self-employed individual.
Plan Contribution Limits: Maximum of 25% of net eligible payroll up to $160,000, indexed by cost of living. The individual limit is the lesser of 25% or $30,000.
Funding Responsibility: Owner contributions only.
Employee Eligibility: Must be offered to all employees at least 21 years old who worked at least 1,000 hours in the prior year, two years if no vesting period.
Vesting: Determined by owner.
Key Advantage: High limits for contributions.
Key Disadvantage: Employees cannot contribute. Must contribute the same amount every year.
* Only 28% of companies with fewer than 100 employees offer a retirement plan. Less than 15% of companies with fewer than 20 employees offer a retirement plan.--from the General Accounting Office, 1996
* Less than half of small employers are familiar with SIMPLEs. One-third know about SEPs, while just over 10% know about money purchase plans. One-third of small employers without retirement plans don't know they can set up a plan for less than $2,000 and can share administrative expenses with employees.--from Employee Benefit Research Institute Small Employer Retirement Survey, 1998
* Only 17% of seasoned, profitable small businesses have qualified retirement plans. Close to 95% of their owners said the most important characteristic they want in a retirement plan is a benefit structure that favors selected participants. Almost 80% said a plan that is easy to administer is most important and close to 70% note that having a plan with tax-advantaged investing characteristics is a top concern.--from Prince & Associates, 1999 n>>>
Got a middle-aged small-business owner who really needs to contribute more than $30,000 a year into a retirement plan? A defined benefit plan is the only way to do it. Recent pension law changes make defined benefit plans more attractive for some.
A defined benefit plan puts no limits on an owner's annual contribution, but it must be set by an actuary and is mandatory. The amount can vary each year. The maximum annual benefit is $130,000, or 100% of a participant's average pay for the highest of three consecutive years. Employees can't contribute and have no control over investment options.
"Defined benefit plans have really picked up in the past two years," says Joseph Balestra, a regional pension consultant for Benetech, a Chicago-based pension consultant and administrator. "A lot of large companies like IBM are hiring employees and setting them up as independent consultants in sole proprietorships. They get paid $100,000 to $200,000 and usually are over 50 years old."
Jim Rafoth has set up about 10 defined benefit plans in the past six months. "We've seen a number of manufacturer reps going out as consultants and setting up a sole proprietorship," says Rafoth, a broker with Beard Pension Services in Youngstown, Ohio. Rafoth also sees a market for defined benefit plans to replace existing SEPs among attorneys and manufacturer reps.
A defined benefit plan works best for a company with an owner and spouse and no more than three employees, Balestra says. Owners must be 45 or older and employees less than 35 years old. "We're seeing a number of companies like this in which the owner makes $100,000 and contributes it all into a defined benefit plan," Balestra says.
