For some successful small business owners, retirement planning is simple (or so they believe): When they decide to stop working, they’ll merely sell their businesses to the highest bidders, experience huge economic windfalls and everything else will take care of itself. In their minds, the value of their business means they don’t need to plan financially like everyone else.
If you’ve ever confronted a client like this, you know it can be difficult to convince them otherwise. It’s not usually hubris or arrogance driving this viewpoint. Rather, it’s their passion. It can be blinding, especially when it comes to their personal finances, sometimes making it difficult for them to fully appreciate what their business is really worth and anticipate market and systemic risks.
Even the strongest businesses can fizzle out when confronted by a disruptive force. Just ask Blockbuster. Advisors, therefore, need to help small business owners understand that they need to approach retirement just like everyone else—and that means a well-diversified plan that considers all possible outcomes.
One good place to start? Consider a company-sponsored 401(k) or defined benefit plan for them and their employees. At first glance, the hazards associated with such plans (outsized administrative costs, interest rate risk, etc.) appear to outweigh any potential upside (a more diversified retirement portfolio). And that would be true in most instances.
But for owners of established businesses with predictable revenues and strong growth prospects, a 401(k) or a pension plan can be an ideal financial planning tool, capable not only of creating an extra bucket of individual wealth but a host of other benefits as well. Consider the following:
Tax efficiency for high earners. Successful small businesses are frequently led by people whose incomes are near or in the top marginal tax bracket. This is an important point because employer-sponsored retirement plans may allow business owners (the sponsor) the opportunity to defer a significant share of their incomes.
For instance, a defined contribution plan, like a 401(k), lets business owners defer up to $53,000 per year. A pension plan permits even more, equaling the participant’s highest average compensation over the course of three consecutive calendar years or $210,000, whichever is lower. In either case, the result could be a significantly lower tax bill.
An important caveat, of course, is that pension plans establish a defined benefit, which entails go-forward obligations that other retirement plan options do not require. That’s why this particular vehicle is appropriate for only well-established enterprises that have stable, consistent and predictable cash flows. Otherwise, even individuals with healthy incomes are assuming too much risk—particularly if they still have other significant debts, such as a child’s college tuition or their mortgage—since they would be responsible for covering any shortfalls should the plan become underfunded.
Their employees could be a very strong demographic match. While it’s hard to pinpoint the average age of an owner of a successful, mature business, logic suggests that most are over 50. Meanwhile, their staffs, even in highly professional settings, like a law practice or architectural firm, are usually younger. This is critical, since the level at which business owners are required to fund a company-sponsored plan, especially a pension, is determined, in part, by the demographic makeup of their employees.
A younger staff creates a larger spread between what the owner can save each year under the plan and their funding requirements. In some instances, that gap can be quite large. Ensuring that the owner realizes an economic benefit that easily offsets what they are legally required to put aside for their staff is, typically, the primary consideration when deciding whether a 401(k) or pension plan is a good solution.
A strong talent recruiting and retention tool. Given the continued lull in interest rates, along with the long-term obligations associated with pension plans, it's hard to find any business that still offers this perk. At the same time, many firms have scaled backed—or even eliminated—their 401(k) offerings. Business owners, to lure and retain top talent, can position their plans as an attractive, increasingly uncommon employer benefit.
Low 'real' plan set-up and administration costs. The costs of creating and maintaining these plans are less onerous than many assume. True, pensions specifically have somewhat high nominal administrative expenses, especially relative to other employer-sponsored retirement plan options. However, such costs are both tax-deductible and relatively minimal when weighed against the full value of the business owner’s potential long-term tax savings.
While on the surface it might seem like helping successful small business owners through the retirement planing process would be somewhat easier, it doesn’t always work out that way. Whatever strategies you choose to pursue, keep in mind that no client should ever be wholly dependent on the performance and the expected valuation of their business to fund their retirement.
Mark Palmerino is a Partner at CCR Wealth Management.