Pension Plans

Related Terms: Employee Benefits; Employee Retirement Income Security Act; 401(k) Plans; Keogh Plan; Nonqualified Deferred Compensation Plans; Retirement Planning

The term "pension plan" is now used to describe a variety of retirement programs that companies establish as a benefit for their employees—including 401(k) plans, profit-sharing plans, simplified employee pension (SEP) plans, and Keogh plans. In the past pension plans were differentiated from other types of retirement plans in that employers were committed to providing a certain monetary level of benefits to employees upon retirement. These "defined benefit" plans, which were common among large employers with a unionized work force, have fallen into disfavor in recent years.

Some individuals also choose to establish personal pension plans to supplement their retirement savings. Making sound decisions about retirement is particularly important for self-employed persons and small business owners. Unlike the ever declining numbers of employees of large companies, who can simply participate in the pension plans and investment programs offered by their employers, entrepreneurs must set up and administer their own plans for themselves and for their employees.

Though establishing and funding pension plans can be both time-consuming and costly for small businesses, such programs are worth the effort for a number of reasons. In most cases, for example, employer contributions to retirement plans are tax deductible expenses. In addition, offering employees a comprehensive retirement program can help small businesses attract and retain qualified people who might otherwise seek the security of working for a company that does offer such benefits.

The number of small firms establishing pension plans grew considerably during the 1990s, but small employers still lag far behind larger ones in offering this type of benefit to employees. According to a 2005 Small Business Administration report, fewer small companies (those with 500 or fewer employees) offer any sort of retirement benefits to their employees than do larger firms—35 percent versus 75 percent respectively in 2002. For firms with five employees or fewer, only 11 percent offer a retirement savings program, like a 401(k) or Simplified Employee Pension (SEP) plan.

PENSION PLAN OPTIONS FOR SMALL BUSINESSES

Small business owners can set up a wide variety of pension plans by filling out the necessary forms at any financial institution (a bank, mutual fund, insurance company, brokerage firm, etc.). The fees vary depending on the plan's complexity and the number of participants. Some employer-sponsored plans are required to file Form 5500 annually to disclose plan activities to the IRS. The preparation and filing of this complicated document can increase the administrative costs associated with a plan, as the business owner may require help from a tax advisor or plan administration professional. In addition, all the information reported on Form 5500 is open to public inspection.

A number of different types of pension plans are available. The most popular plans for small businesses all fall under the category of defined contribution plans. Defined contribution plans use an allocation formula to specify a percentage of compensation to be contributed by each participant. For example, an individual can voluntarily deduct a certain portion of his or her salary, in many cases before taxes, and place the money into a qualified retirement plan, where it will grow tax-deferred. Likewise, an employer can contribute a percentage of each employee's salary to the plan on their behalf, or match the contributions employees make.

In contrast to defined contribution plans are defined benefit plans. These plans calculate a desired level of benefits to be paid upon retirement—using a fixed monthly payment or a percentage of compensa-tion—and then the employer contributes to the plan annually according to a formula so that the benefits will be available when needed. The amount of annual contributions is determined by an actuary, based upon the age, salary levels, and years of service of employees, as well as prevailing interest and inflation rates. In defined benefit plans, the employer bears the risk of providing a specified level of benefits to employees when they retire. This is the traditional idea of a pension plan that has often been used by large employers with a unionized work force.

In nearly every type of qualified pension plan, withdrawals made before the age of 59 1/2 are subject to an IRS penalty in addition to ordinary income tax. The plans differ in terms of administrative costs, eligibility requirements, employee participation, degree of discretion in making contributions, and amount of allowable contributions. Free information on qualified retirement plans is available through the Department of Labor at 800-998-7542, or on the Internet at www.dol.gov.

The most important thing to remember is that a small business owner who wants to establish a qualified plan for him or herself must also include all other company employees who meet minimum participation standards. As an employer, the small business owner can establish pension plans like any other business. As an employee, the small business owner can then make contributions to the plan he or she has established in order to set aside tax-deferred funds for retirement, like any other employee. The difference is that a small business owner must include all nonowner employees in any company-sponsored pension plans and make equivalent contributions to their accounts. Unfortunately, this requirement has the effect of reducing the allowable contributions that the owner of a proprietorship or partnership can make on his or her own behalf.

For self-employed individuals, contributions to a qualified pension plan are based upon the net earnings of their business. The net earnings consist of the company's gross income less deductions for business expenses, salaries paid to nonowner employees, the employer's 50 percent of the Social Security tax, and—significantly—the employer's contribution to retirement plans on behalf of employees. Therefore, rather than receiving pre-tax contributions to the retirement account as a percentage of gross salary, like nonowner employees, the small business owner receives contributions as a smaller percentage of net earnings. Employing other people thus detracts from the owner's ability to build up a sizeable before-tax retirement account of his or her own. For this reason, some experts recommend that the owners of proprietorships and partnerships who sponsor pension plans for their employees supplement their own retirement funds through a personal after-tax savings plan.

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