As the owner of a small business, you can choose from a range of retirement plans. Yet while there are important variations among the many possibilities—401(k)s, simplified employee pensions (SEPs), defined-benefit pension plans, and others—they basically fall into one of two categories depending on who is responsible for funding and using the plan. With old-style pensions, your business promises employees a specific retirement benefit, generally a function of salary and years of service (as a lump sum or a lifetime annuity). In contrast, 401(k)s and other defined-contribution plans put the burden on employees to save and invest a retirement account and then decide how and when to tap it.
Beginning in 2010, a new hybrid—the defined-benefit 401(k) plan, dubbed the DB(k)—combines features of both types. A DB(k), authorized by the Pension Protection Act of 2006 and available to companies with two to 500 employees, provides a small but guaranteed company-paid lifetime monthly retirement benefit while letting workers also fund a 401(k). One major attraction is that DB(k)s are exempt from the strict nondiscrimination rules that normally apply to 401(k)s and other tax-advantaged retirement plans. But the fact that the DB(k) supplements employees’ savings with guaranteed cash also has its appeal at a time when the bear market has cut deeply into 401(k) account values.
The 401(k) part of the DB(k) is subject to the same rules as normal 401(k)s. Employees can direct as much as $18,000 of pre-tax salary into the plan in 2017 (and those age 50 and older may put away a maximum of $24,000). Participating workers can bolster these dollars with optional employers' matching contributions, with total yearly savings capped at $54,000. Workers (and business owners) who achieve those maximums should, over a working lifetime, amass a reasonable nest egg. But how much participants save, and how they invest the savings, is left up to them, and there's no guarantee they'll have enough to fund a long, comfortable retirement.
Nondiscrimination rules can be another stumbling block for business owners and other high-income workers enrolled in traditional 401(k)s. Such plans must meet strict requirements to ensure that highly compensated employees (HCEs) don’t receive a disproportionate share of retirement plan benefits. If lower-paid employees choose not to participate, those at the top of the compensation ladder may find their own contributions restricted.
The defined-benefit 401(k) uses a waiver of those rules to encourage business owners to adopt this new-style retirement plan, which supplements savings with a defined retirement benefit that’s normally based on “final average pay.” The plan must provide a benefit equal to 1% of an employee’s final average salary multiplied by years of service, with a maximum annual pension equal to 20% of final pay. Meanwhile, the 401(k) part of the plan requires automatic enrollment of employees (who must opt out if they don’t want to participate) and an employer’s contribution equal to 4% of compensation. Your business’s matching contribution rate for HCEs can’t exceed the matching rate for non-HCEs, and you must immediately vest employees in their 401(k) accounts.
A second option for determining benefits is a cash balance approach that specifies annual minimum company commitments based on employees’ ages. In this case, your business must set aside at least:
2% of compensation for participants age 30 and under
4% of compensation for participants between age 30 and 40
6% of compensation for participants between age 40 and 50
8% of compensation for participants age 50 or over
Plans that meet all of the requirements of a DB(k) need file only one document for the plan and one annual IRS Form 5500—even though this hybrid really consists of two separate plans. And no other testing is required.
Some experts expect the DB(k) to be particularly attractive to small professional groups—physicians, attorneys, accountants, architects. It can build up substantial retirement savings in a short time, and though it mandates a significant employer contribution, that could be an advantage for owners looking to fund their own retirements. Moreover, as the economy rebounds and businesses again compete for the best workers, offering a DB(k) could make your company stand out.
This article was written by a professional financial journalist for Advisor Products and is not intended as legal or investment advice.