Pension Trends   Volume IV, No. 2, May 2003   printer friendly

In this issue...

Taking Advantage of a Defined Benefit Plan in a Down Market

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Taking Advantage of a Defined Benefit Plan in a Down Market

Author Profile:  This article was written by Alan J. Stonewall, FSPA, EA, MAAA.  Mr. Stonewall is the former president of the American Society of Pension Actuaries, former chairman and board member of the Actuarial Standards Board. Mr. Stonewall also founded Stonewall Pension Service in 1979, and prior to his current position as Consulting Actuary at IAI, he was Director of Employee Benefits at Deloitte & Touche. If you would like to contact Mr. Stonewall or any of the Consulting Actuaries at IAI, please call 1.888.643.5179.

What we first heard anecdotally has more recently been documented in several surveys: many 401(k) participants are having to delay their scheduled retirement due to significant and sustained stock market losses. The length of the delay is typically five or more years. Of course, no one really knows. It all depends on how the markets perform in the future.

It is not hard to understand this phenomenon. Consider John, a 50-year old small business owner who in 1999 at the market’s peak had 40% of his account in growth stocks, 40% in S&P stocks, 10% in international stocks, and 10% in fixed income. His account had been growing at an average of more than 15% per year throughout the 1990’s. His account balance had grown to $400,000. Between his salary deferral contributions and the employer’s contributions, plus a “modest” 10% annual investment return in the future, he would have over $1.0 million by age 56. At 12% he would have nearly $1.2 million. He was set.

Today John’s account is worth about $250,000. His outlook for the future is a hoped for 8% or 9% annual investment return, but he is only counting on 7%. At 7% he won’t get to $1,000,000 until age 60. Today’s realities are much different than yesterday’s expectations.

Now consider John’s twin sister, Jane. She, too, is a small business owner. She, too, has suffered significant investment losses in her plan over the past three years. She, too, has about $250,000 of retirement plan assets. Her situation is similar to John’s with one BIG exception. Her business sponsors a defined benefit plan. This gives her one BIG advantage over John.

If Jane wants to and can afford to, she make substantially larger tax deductible contributions to her retirement plan over the next few years and still retire at age 56 with her $1.0 million nest egg. She does not have to delay her scheduled retirement.

Jane, in fact, at least three options. If Jane’s business finances will not support substantially higher pension plan contributions, she can amend the plan to lower the retirement benefits to what she can afford. She sets the funding target. John, on the other hand, can only retire on what is in his account. He does not have control over his target retirement income. Another bad investment year in the year before his scheduled retirement could set him back again.

Jane’s second option is to leave the plan alone and increase her funding to the plan to make up for the investment losses. There is no reason she has to accept either a later retirement date or a lower standard of living in retirement. Jane may do what other small business owners do in the years just before retirement: take substantially less salary and bonus out of the business and pour as much as possible into the retirement plan. Again, you cannot do that in a 401(k) plan because contributions are tied to the salary you earn. In a defined benefit plan the contribution is typically based on a participant’s highest three-year average salary, whenever that was earned.

Jane’s third option is the same as John’s. She could convert her plan to a 401(k) plan and let the investment gods dictate what her retirement will look like. But why would she do that? She already has the best of both worlds.

Editor’s note: There are lots of reasons for a small business to sponsor a defined benefit plan. There are also reasons not to. If you or your client want to learn more, give us a call at 503.520.0848. We’d be happy to discuss the pros and cons with you.

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This newsletter has been published in order to share general information with our professional contacts. The information presented in this newsletter should not be relied upon without first seeking the advice of a CPA, Attorney or other benefit professional.