NAVIGATING THROUGH THE RETIREMENT PLANNING MAZE
Bill Jones, founder and president of ABC Company, has decided his15-person operation has reached the stage that it could support some kind of employee retirement plan. As a business owner, he wants to provide an additional incentive to retain key staff members.
But Jones is also concerned about the effect of any retirement plan on the firm's tax position and cash flow. And he doesn't want to get in over his head with paperwork and record- keeping. Even though Jones has done some general reading on retirement plans, he still doesn't feel he has sufficient information to make decisions that will have an impact on ABC's financial statement for many years to come.
Sound familiar? As an entrepreneur, you probably know exactly how Jones feels. Implementing a retirement plan may be a nice benefit for employees, but ultimately it is an important business decision that can affect a company's tax position and financial statement for as long as the plan remains in effect.
While small firms are often the most in need of retirement plans, they are also frequently the last to consider them. The U.S. Small Business Administration (SBA) reports that approximately 41.8 percent of all employees work in companies of 100 employees or less, fewer than 15 percent of which offer retirement plans. The need has become so great that the Department of Labor implemented a national campaign in 1995 to encourage owners of companies of every size to establish retirement plans for employees. With the average American spending 18 years in retirement, and with retirement capital of $100,000 lasting only 10 to 13 years, the potential dearth of retirement funds is dramatic.
What is causing the lag between retirement need and planning? Like Jones, many employers cling to the belief that:
* Establishing a retirement plan is too complicated a process.
* Retirement plans require too much paperwork.
* Retirement plans are too costly to administer.
* Retirement plans involve government and tax regulations, which are difficult to follow.
* Maintaining a retirement plan requires advanced computer technology.
Tip About 401k
Many small businesses overlook retirement planning for themselves and don't think that they can afford them for their employees. Retirement plans can be a great benefit for both you and your employee, and there are low-cost options available for small businesses. Target Laboratories (www.targetlab.com) a small company, is maximizing the benefits of the 401k, by providing professional 401k investment advice to company employee.
There is certainly an element of truth in these points for small businesses that try to set up retirement plans on their own. However, with the variety of plans now available, many employers have found a fast, easy route through the retirement maze by working with full-service pension providers who establish, maintain, and handle all the record-keeping on retirement accounts.
"While the myth persists that mainstream, full-service pension providers are only for large corporations, nothing could be further from the truth," asserts Richard Weinstein, vice president and associate actuary of Plan Administration for Transamerica Pension Services, one of the largest pension providers in the country. "With small business becoming an increasingly important force in the American economy, many companies such as ours have created and priced new programs specifically for companies with fewer than 250 employees. And by working with professionals, a small business owner can be assured that the plan will be developed and maintained correctly at less overall expense than if the firm's own resources were used to accomplish the same tasks.
"No entrepreneur would consider setting up a bank account without enlisting the resources of a financial institution," Weinstein points out. "It's amazing how many employers don't apply that same logic to their retirement plans."
While the cost of a retirement plan prevents many small business owners from proceeding, it's important to remember that an equally high cost may be entailed if a plan isn't established. Companies that put off starting a retirement plan often find it difficult to attract and retain the right employees, especially in more competitive industries. Keeping key staff members is a critical determinant in the success of small businesses, and retirement plans often help by providing extra incentive for employees to stay.
Starting the Process
Once a business owner has decided to take the plunge, how does he begin?
The first step is to answer five critical questions about your employees. Unlike health care plans, in which the number of employees can be a key consideration, a different set of elements are germane for retirement plans:
1. What percentage of your work force is nearing retirement?
2. What percentage of your work force is relatively young and mobile? They may be more concerned about benefits they can take with them if they leave the company.
3. What percentage of your employees are lower salaried? How many are high salaried?
4. What percentage of your employees do you consider "key"? And how many of these are older in age? As will be described later, special "age-weighted" plans exist that tend to favor older, more long-term and possibly also highly-paid employees.
5. What percentage of your work force is long-tenured, or is turnover fairly high? The answer will affect what kind of vesting schedule you would implement, e.g., vesting in five, six or seven years.
Finding the Right Pension Partner
After preparing schedules that answer these questions, the next step is to look for the right professional help to get your company started on the road to retirement planning. As there are many insurance companies and mutual fund providers who would like your business, take time to shop around and make comparisons. Here is a 14-point checklist to help you through this process:
1. Talk with your employee benefits specialist or broker.
2. Call business colleagues to obtain referrals or contact the local chamber of commerce to request a list of bonafide retirement plan providers.
3. Ask your tax accountant and business attorney for their recommendations.
4. Select a group of three or four prospective candidates. Meet with them individually and present the schedules of your work force, per the above questions.
5. In discussions with the candidates, make sure you understand the terminology and jargon of the pension industry. For example, an employee who participates in a pension plan is called a participant.
6. Evaluate each candidate's overall investment portfolio and performance for the past five years.
7. Inquire about the services offered by the various candidates. Look for a company that can supply "turnkey" packages in which all materials are provided, including employee educational materials. Also look for a provider who is fully integrated, so investment management and reporting can be included in the plan.
8. Inquire about the kinds of plans that should be considered. Take sufficient time to educate yourself about the differences between defined contribution and defined benefit
plans. Consider which plan - or both - should be implemented.
9. Ascertain whether each candidate undertakes IRS compliance and reporting.
10. Investigate the kinds of educational programs the candidates present to employees.
11. Obtain definitive costing information for setting up the plan, ongoing administration fees and investment charges.
12. Inquire about a time line for implementing the plan so you can compare each provider's efficiency and thoroughness as it relates to your company.
13. Review your tax liabilities with a tax or financial consultant and clearly define your company's current and projected income and growth.
14. Finally, meet with your business attorney to verify the latest legal and regulatory issues. Make sure you understand the non-discrimination requirements, your firm's fiduciary responsibilities, and the annual review process to ensure that the chosen plan meets compliance.
Benefits of a Full-Service Provider
Investment variety and performance are significant factors in demonstrating options and growth to your employees. According to Weinstein, "As an employer, you want to offer a plan with enough variety so that your people have a good mix of low-risk, medium- risk and high-risk funds. You also want to show that monies invested through a retirement plan will earn substantially more than an employee's individual investment in a single hand-picked stock. For example, our equity fund for the year ended December 31, 1995 returned 44 percent compared with returns of 38 percent from the Standard & Poor's 500 Stock Index.þ On the low-risk side, our cash management fund returned right on track with IBC/Donoghue First Tier Index - more than five percent for the same period. Choice and track record are paramount in selecting a plan provider," he reiterates.
Business owners will also want to investigate the level of service that will be included. How is record-keeping handled, and when are statements issued to employees? What regulatory forms and reports will the plan provider complete? How often will your investment strategy be reviewed to ensure it is meeting your employees' needs?
Another good reason to work with a full-service company is the expertise that is provided for IRS compliance and reporting. Your plan must meet certain IRS discrimination tests, and the proper documents and forms must be completed in a timely fashion.
Similarly, periodic reports must be provided to plan participants to demonstrate fund performance and the current value of each participant's benefits in the plan. Most employers, even those with a few employees, find that they do not have the time for such records, and the process often becomes overwhelming because governmental regulations change, are often ambiguous and employees come and go. Much like using an outside payroll service, it makes good sense to take advantage of a full-service provider's ready knowledge, technology and service capabilities to accomplish these tasks on your behalf.
You will also want to explore the extent of employee educational materials your prospective plan provider will offer. To obtain the most use of -- and appreciation for -- the retirement plan being developed, employees must be educated about its benefits. A full-service provider should have a plethora of data, from regular newsletters to introductory brochures and other marketing and educational materials. Many full-service providers will actually schedule meetings with your employees and introduce them to the plan.
Of course, cost is a major consideration. Fortunately, set-up and ongoing administrative costs have dropped sharply in recent years. Pricing varies depending on the plan selected and the number of eligible employees. With a 401(k) plan, for example, with 25 to 200 participants, the setup fee ranges from
$600 to $1,500. Annual administrative fees are typically $3,000 to $5,000, with some companies charging a minimal flat rate plus a fee per participant. Inquire about annual contract and investment management fees as well.
Which Plan: Defined Contribution or Defined Benefit ... or Both?
Once you have selected a provider, explore the two categories of retirement plans:
* "Defined Contribution" plans. Employers make annual, discretionary or periodic contributions to participants based on a percentage of a participant's salary, age, years of service, company profits or a combination of these factors. Employer contributions are fixed for money-purchase and flexible for profit-sharing. The plans may be designed to include pre-tax or after-tax employee contributions, which may be voluntary or mandatory. Defined contribution plans include money-purchase pension plans, profit-sharing plans, 401(k)& plans and stock bonus plans. According to the Department of Labor, in 1991 nearly 600,000 companies offered defined contribution plans. Because a participant's benefit equals the amount to which the contribution grows by retirement, this plan tends to favor younger employees because the accumulation period is longer.
* "Defined Benefit" plans. Each employee's future benefit is determined by a specific formula; the employer must contribute an amount necessary to provide the guaranteed level of retirement benefits. Employees generally do not contribute to the plan. The benefit is usually not payable until participants reach retirement age, nor can participants withdraw the benefit and take it if they change jobs. Providing a specific monthly amount at retirement, a defined benefit plan tends to favor older employees.
Exploring Defined Contribution Plans
Defined contribution plans became popular with the enactment of the Employee Retirement Income Security Act of 1974, more commonly called ERISA. Subsequent legislation during a more than 20-year period has made defined contribution plans more flexible than ever before.
It is vital that employers stay up to date with legislation, as Ridgewood Power Corporation discovered in modernizing its existing 401(k) plan.
"We explained that IRS regulations now allow `cross testing,' which permits employers to categorize participants into two or more `classes' and make much larger contributions to the plan for one class than for another," states Derek O'Neill, who served as Ridgewood Power's pension representative. "As long as projected benefits for all classes are comparable at retirement age, the plan would generally pass discrimination tests."
Here is a quick review of the various defined contribution plans now available to companies of any size:
401(k) (Sometimes called a "Salary Reduction" or "Cash or Deferred Arrangement"[CODA] plan).
* A profit-sharing plan with a salary reduction feature. Can incorporate discretionary employer matching contributions, contingent on profits.
* The most popular retirement plan because employer costs are generally lower compared with other retirement plans. However, employers must strictly follow IRS compliance and non-discrimination rules.
* Participants elect whether or not to defer a portion of their compensation.
* Employers may also make profit-sharing contributions, which can vary from year to year.
* In 1996, participants can defer up to 15 percent of their gross pay to a maximum of $9,500. Employers may match part or all of a participant's contributions.
* Total annual additions to a participant's account could be as much as 25 percent of compensation, up to $30,000 per participant. The $30,000 limit includes all contributions, e.g., deferrals and employee after-tax profit sharing.
* Vesting periods range from immediately to a seven-year graded period for employer contributions; employee-elective contributions are always 100 percent vested.
* Payroll deductions are an easy way to save, and contributions are excluded from federal and most state and local taxable income.
* There are numerous options, including how much to save and how to invest. No decisions are permanent -- contribution amounts may be increased, decreased or suspended, and the funds may be rolled over into another retirement plan or an IRA upon separation from service.
* Participation is available more readily; the eligibility requirements vary. For example, employers can require six months, no age and no service, or 21 years of age and at least one year of service (1,000 hours) with the company.
* Employees are generally not allowed to withdraw their elective contributions before age 59 1/2 except in case of hardship, although they can obtain loans from their accounts if the plan so specifies.
Age-Weighted Profit-Sharing Plan
Age-weighted plans contain many of the same features discussed in the prior section. However, these plans add the following considerations and advantages:
* Ideal for small-to-medium-sized businesses with older and more often highly compensated employees who want to maximize contributions.
* Employers can still vary contributions annually based on business profits.
* Allocates a larger portion of the employer's contribution to older, frequently long-term participants (who are often more highly paid) or the owners.
* May have a 401(k) feature in which employees can contribute up to the maximum allowed by law. The maximum of $30,000 or 25 percent of compensation per participant may be allocated based on the age-weighted profit-sharing formula.
SEP (Simplified Employee Pension)
* In simple terms, this plan may be considered an employer- sponsored individual retirement account (IRA) because all funds must be invested in IRAs.
* Designed primarily for sole proprietors and small businesses; record-keeping and reporting are kept to a minimum.
* A SEP plan works best for employers with a stable, full-time workforce.
* Setup and administration costs are minimal; no IRS filings are required for a model SEP.
* Employers can contribute up to 15 percent of each participant's pre-tax compensation or $22,500 per participant, whichever is less.
* Most employers provide several investment options, including CDs.
* Contributions can vary from year to year, depending on business profits.
* IRAs do not offer the same protection from an employee's creditors as profit-sharing pension plans.
* Participation is required for all employees who are at least 21 years of age, have worked for the company during at least three of the five preceding years, and earn $400 or more in the current year.
* Participants make no contributions.
* Vesting is immediate so no funds are forfeited upon termination.
* Participants have full control over investments because they can transfer or roll over to other IRAs.
SARSEP (Salary-Reduction Simplified Employee Pension or SEP CODA plan)
* Designed for use by firms with 25 or fewer employees, it is easy for companies to outgrow this type of plan.
* Allows participant salary deductions. All contributions are invested in IRAs.
* Setup and administration costs are very low, typically less than $400, and no IRS filings are required for model SEPs.
* Participants make the majority of contributions; the company can make additional contributions (see SEPs, above).
* Participants may contribute as much as 15 percent of their annual salary to a maximum of $9,240.
* At least 50 percent of eligible employees must participate.
* Regulations are strict to keep highly compensated employees from contributing more than lower-paid employees.
* Employee contributions are not considered compensation and therefore are excluded from taxable income.
* Eligibility is the same as with SEPs, as described above.
Exploring Defined Benefit Plans
Even if you have already decided to establish a defined contribution plan, carefully consider adding a defined benefit plan as well. Unlike defined contribution plans, most defined benefit plans are customized according to the specific benefit formula the company wants to use:
* Dollars multiplied by service formula. Accrues a flat dollar amount for every year of service the plan recognizes.
* Career-average formula. Either accrues a percentage of salary for each year in the plan, or averages the participant' annual earnings over the entire period of plan participation.
* Final-pay formula. Accrues benefits based on average earnings during a specified number of years at the end of the participant's career multiplied by service recognized by the plan.
A number of different factors determine the final cost of the plan, including the rate of return on investments, the vesting schedule, the number and ages of employees, turnover and future pay levels. Plans must satisfy minimum contribution requirements; however, there is some flexibility in setting contribution levels from year to year.
* A good choice for small businesses that have adequate cash flow and can use a large tax deduction.
* Provides the owner(s) and employees a guaranteed level of benefits upon retirement.
* Employers make regular contributions to fund the benefits of each participant.
* Employers carry the risk of guaranteeing retirement benefits.
* Employers can minimize unknown factors by projecting future interest earnings, mortality rates, personnel turnover and salary increases.
* Certified actuarial and other professional services are required.
* Tends to favor older employees by providing known security at retirement.
* Can provide substantial benefits for long-term or life-long employees.
* While there are contributing defined benefits plans, generally participants do not contribute so there are no payroll deductions.
Many employers believe that the most effective retirement program combines both defined contribution and defined benefit plans. Some combine a defined benefit plan that provides a small pension with a 401(k) plan.
Educating Your Employees
No retirement plan is effective if employees are not well educated as to how the plan benefits them and the large dollar amounts that will be required. In this regard, it's helpful to emphasize that just a little bit of savings can go a long way. Using accumulation tables such as the one shown above can be very effective in demonstrating how a minimal contribution accumulates over time to provide a large retirement benefit. It's also useful to point out that pre-tax savings will not detract markedly from an employee's take-home pay.
When educating employees, a key ingredient is simplicity; information needs to be presented in layperson terms. Your pension consultant should be able to clearly explain financial terminology, investment options, asset allocation and tax advantages. In fact, the better pension providers go so far as to provide ready-to-use pamphlets, memos, and "one-sheets" to create interest among your work force and a ready understanding of the real value of retirement plans.
Remember also that education is not a one-time-only event. Employees need constant refreshers about their investments, particularly since many plans allow investment changes on a quarterly basis.
Bill Greer, president of the life and health division of Smith Reagan Insurance in San Benito, Texas, discovered an added benefit when the company implemented a 401(k) plan for its 14 employees. "Since employees are responsible for selecting their own investments, they are becoming more cognizant about financial news and the business world."
Greer worked with his full-service provider to enhance plan effectiveness by making use of some of its programs.
"We took care of the entire process, from presenting instructive and entertaining videotapes to conducting on-site enrollment meetings," notes Marshall Pearson, the pension representative who assisted Smith Reagan. "The company also opted to take advantage of our easy calculation tools, payroll enrollment stuffers, and toll-free, 24-hour hotlines, which plan participants can use to check investment performance or request fund transfers."
While some businesses have made big strides in educating employees, most don't utilize all the resources available to them. According to the Pension and Welfare Benefits Administration, one-third of American workers who have access to a 401(k) plan don't participate. If employees fully understand what their retirement contributions mean down the road, and can see the earning power of even a five or six percent contribution, the number of contributors would be likely to rise dramatically.
Additional non-profit websites that include relevant unbiased information about 401k plans include: www.irs5500online.com and www.mutualfund401k.com
Get Started Today
The essentials offered in this article to clarify various retirement plan options are just that - essentials. Without professional help, the average small business owner can quickly become lost in the maze. The wisest path is to carefully weigh all of the issues before selecting a retirement plan, choosing a pension provider, and educating employees about their retirement benefits.
To obtain more information about retirement plans, contact the Department of Labor, the Employee Benefit Research Institute, or the American Savings Education Clearinghouse in Washington, D.C.
HOW MUCH CAN YOU SAVE?
The following accumulation table was designed to demonstrate how a small amount of monthly elective contributions can accumulate to provide a participating employee with a large retirement benefit.
Several assumptions were made in the calculation of the amounts shown in this table, and therefore the table does not reflect the actual amount a participant might receive, even if age and compensation are the same as shown below. This table was intended only as an example to show how the combination of elective contributions and employer matching contributions can grow into a substantial amount over a number of years.
It will be assumed that elective contributions equal to 6% of monthly compensation began when the participant was age 21 and 40, respectively. It is also assumed that all contributions have been placed in a guaranteed interest account (fixed-income fund) and have earned 7.25% interest, compounded annually. The table assumes no salary increases and a matching contribution of 100%. Any additional employer contributions would increase the amount accumulated at age 65.
Participant Starting Age 21
|| Mo. Retire
|| at Age 65
|| Benefit on a
|| at 7.25%
|| Life Annuity
|| $ 50.00
|| $ 50.00
|| $ 356,810.00
|| $ 3,066.00
Participant Starting Age 40
|| $ 50.00
|| $ 50.00 $
|| $ 702.00
Courtesy of Transamerica Pension Services
PROFIT-SHARING PLAN REWARDS EMPLOYEE LOYALTY
Robert Swanson, president of Ridgewood Power Corporation in Ridgewood, New Jersey, enjoys boasting about low turnover among the company's 80 employees.
"Our excellent benefits are a main reason employees stay with us. We have liberal medical and dental benefits and recently improved our existing 401(k) plan," he notes.
Ridgewood Power is an energy company that buys co-generation plants throughout the country. "Major sources of energy escape in the burning of gas or coal. We capture the heat and reuse it," Swanson explains. One of the company's 11 facilities burns municipal waste to generate steam used by the paper mill that produces all the paper used for U.S. currency.
With the firm's profits increasing steadily, Swanson was concerned about tax savings and finetuning Ridgewood's original 401(k) plan. He was particularly interested in a plan that would reward the loyalty and dedication of the company's older, long- serving, and predominantly highly compensated staff.
Through Reynen Associates and Transamerica Pension Services, employee benefit specialists, Swanson learned about the features of a new comparability plan. This is a type of profit-sharing plan that allows a substantial allocation of contributions to long-term and typically older employees. In some cases, annual contributions can be as high as 25 percent of pay or $30,000 for older, more highly compensated participants, with as little as three percent of pay allocated to younger, less highly compensated participants.
"The new comparability plan fits better with our long-term objectives. It provides a better tax savings and employees get more benefits," Swanson points out. "The company has also added a 50 percent match to every employee dollar, and we're able to vest everyone immediately in the plan in full.
"I've seen too many cases where employees just waited around to become vested and were totally unproductive," adds Swanson. "I want our people to be able to take their money with them when they leave the company. With this new comparability 401(k) plan, they can do exactly that."
INCENTIVE RETAINS YOUNGER STAFF
"We needed an incentive to help retain our younger employees," prefaces Pennie Weber, vice president of operations at Sky Trek, in explaining why management decided to add a 401(k) to its existing retirement plan.
This 30-person aircraft charter company based in Modesto, California has been servicing all levels of planes, from single- engine vehicles to large jets, since 1982. In addition to its main facility in Modesto, Sky Trek maintains operations in nearby Merced and at Mammoth Lakes in the upper Sierra Nevadas. With employees located in different areas and working varied shifts, setting up a 401(k) plan was less challenging than staging the educational seminars required to get the program off the ground.
"We wanted to make sure everyone attended a seminar and understood the 401(k) plan," Weber explains. "Our pension provider spent hours with us and made several presentations to accommodate our employees. They simplified the financial material and were extremely informative." According to Weber, an important element in the success of the educational programs was an emphasis on contribution amounts.
"Employees didn't realize that deducting as little as $1.98 a week can accumulate into a substantial amount by retirement," she says. "Maybe retirement is worth one less hamburger per week."
Weber was pleased with the costs involved in implementing the 401(k) plan, noting that "the administrative fee was much more reasonable than I expected. And we don't have the time or the knowledge to handle our own record-keeping. That's one of the reasons we hired Transamerica Pension Services, so they can oversee the process and deal with the details."
Weber hopes to offer additional benefits by adding a matching contribution at the end of the year. "We will look at our yearly financials; if we make money, our employees will make money. We're working toward a common goal."