Defined benefit pension plans make more sense than profit sharing for most owners of small companies.
Again and again clients ask me: "Which is better -- a profit-sharing plan or a pension plan?" Since the person asking the question is almost always the highest-paid person in the company, it's logical that the answer be whichever maximizes his or her benefits. For most owners or stockholder-employees of closely held companies, the answer is a defined benefit pension plan.
The relative advantages to highly paid employees are simply summarized below: Fixed-benefit Profit-sharing
Key elements pension plan plan
High salary Yes Yes
Age (older) Yes No
Integration Big Small
Credit for years Not
of service Important Important
Leaving aside Social Security Integration, which is a relatively complex point, clearly the pension plan favors characteristics common to most owner/stockholders. Look at the table below to compare the results of a profit-sharing plan to a pension plan for a hypothetical small company.
Annual Contribution to plan:
Participant Age compensation Profit-sharing Pension
Boss 55 $100,000 $10,000 $27,455
Son 25 55,000 5,500 1,557
Tarzan 45 30,000 3,000 2,310
Jane 30 15,000 1,500 none
$200,000 $20,000 $31,322
ntage of profits to be contributed to a profit-sharing plan is usually adecision of the board of directors. Normally if there were no profits in a given year there would be no contributions. The hypothetical company used above is profitable, however, and has decided to fund its plan with a fixed percentage of salaries, in this case 10%.
The same company's funding of a pension plan, however, is very different. When you adopt a defined benefit pension plan (which means that the benefit to be received is predetermined) there are two fundamental decisions to be made: First, how are the benefits for each participant to be determined? And second, how much does the company have to contribute to the plan each year to fund benefits for the participants?
The answers to these questions usually make the pension plan much more flexible and valuable than a profit-sharing plan to the owner or stockholder-employee. Although there are rules that govern the number and type of employees who must be allowed to participate in a pension plan, there is great flexibility in them; generally a plan can be set up to maximize benefits to those management feels deserve them most.
Benefits are normally derived from four types of formulas:
1. FLAT AMOUNT.Assume that the benefit desired is $100 per month per participant. Salary and length of service are immaterial; all employees receive the same pension.
2. FLAT PERCENTAGE. Assume that the desired benefit is 30% of annual compensation, or 2 1/2% per month. Using this formula, the boss in our hypothetical company would receive $2,500 per month after retirement. His length of service is still immaterial.
3.FLAT AMOUNT FOR EACH YEAR OF SERVICE. Assume that the desired benefit is $10 a month for each year of service. The boss has been an employee for 30 years, so his added benefit would be $300 a month. Time is beginning to count.
4. PERCENTAGE FOR EACH YEAR OF SERVICE. Assume a desired benefit of 1% of compensation per year for each year of service, or 1% X 30 years X $100,000. Time and salary are both important.
These formulas can be combined in dozens of ways to achieve the desired result. How much the company has to contribute to the plan to achieve the benefit amount desired is determined actuarially. In the case of our hypothetical company, the age of the boss as well as his higher predetermined benefit level led to a sharply higher contribution to the pension plan than to the profit-sharing plan: 88% of the total contributed instead of 50%. Jane, as an employee receiving less than $29,700 a year, does not have to be included in the plan at all, a result of Social Security Integration rules. Of course, the basic actuarial assumption about the life expectancy of the boss plays a major role as well.
Defined benefit pension plans are a complex area and require the advice of a professional to achieve proper results. But the many variations available to the principal beneficiaries of the pension plan make it an attractive vehicle for most owners of closely held companies.