A tight labor market requires careful attention to employee benefits. Employer-sponsored pension plans are central to these packages. Retirement plans include pensions, 401(k)s, stock bonus plans, and many others. Plan designs vary, but they all serve similar purposes. Retirement plans attract and retain the best talent. An appropriate plan also meets the financial goals of an entity.
Preparing for retirement has always been important. Extended life expectancy and rising health care costs now make it a necessity. The data reveal the full extent of both trends. Mortality tables show that today’s 65-year-olds have a 50% chance of living to age 90. Moreover, there is almost a 20% probability that they will live to be 100 years old. The leaps in life expectancy are partly attributable to advances in health care. Medical interventions ward off fatal diseases and life-sustaining treatments keep our patients alive longer. However, these innovations come at a cost. Experts estimate that the average couple could incur approximately $315,000 in retirement health care expenses. Longer and more expensive retirement periods require significant savings.
The costs of retirement are widely recognized. As such, many workers embrace and even expect employer-sponsored retirement plans. The research ranks retirement plans as one of the top three priorities for future workers. Additionally, three-quarters of employees say they would change jobs for better financial benefits. Businesses are responding to these concerns. In 2020, roughly two-thirds of private sector workers had access to employer-provided plans, and most took full advantage. Broad participation leads to a more satisfied, engaged and productive workforce.
Employer-sponsored plans offer clear personnel advantages. They also facilitate the organization’s financial objectives. Some plans favor older business owners and other plans are better suited for early-stage entrepreneurs. Contribution preferences are also important, as some plans have higher contribution limits than others. Employer strategies are plentiful.
Business characteristics also drive plan selection. The business model, staff composition and liability preferences of the economic entity are key. Organizations with fixed income can choose plans that require annual contributions. In contrast, entities with fluctuating earnings may choose more flexible options. Businesses with high turnover may have more stringent qualification requirements than those with a stable workforce. Finally, the complexity of the plan varies greatly. Some organizations are better equipped to handle the administrative burden and liability concerns than others.
The choices may be overwhelming, but the takeaway is simple. There is a plan for every business. It is up to businesses to choose wisely.
Types of plans
Any discussion of benefits requires a basic understanding of the types of plans. Pension plans fall into three broad categories: defined contribution schemes, defined benefit schemes and non-qualified schemes. Each type responds to particular purposes and circumstances.
Most are familiar with defined contribution plans. These include standard 401(k) plans where the employee makes a defined contribution each pay cycle. Contributions can be pre-tax or post-tax. Some 401(k)s also offer employer matching contributions or year-end profit sharing distributions. Employees make investment choices and market returns determine future account balances. Other defined contribution plans include money purchase plans, defined benefit plans, and stock bonus plans.
Defined benefit plans guarantee fixed retirement benefits to employees. Sponsoring companies fund large reserve accounts to support this promise. Defined benefit plans, also known as pension plans, have fallen out of favor in recent decades.
The third category is non-qualified plans. These plans are best characterized as simple and flexible. Nonqualified plans avoid federal eligibility, vesting, and contribution requirements. However, employers usually lose some tax advantages in return. Non-qualified plans are sometimes referred to as “Top Hat Plans.” They are useful tools that attract top talent and retain top executives.
Plan options continue to expand as laws and preferences change. The table below shows the breadth of retirement plan options. Details of the plan, advantages and pitfalls will be discussed in future articles.
A transformed landscape
The retirement landscape has changed significantly in recent decades. While past generations received guaranteed pensions, today’s workers are largely responsible for funding their own retirement. This reflects decades of evolution in retirement plan design. Nowadays, traditional pension plans are used only in limited circumstances.
Pensions extend guarantees in an uncertain world. The plan structure requires frequent, predetermined payments to retirees regardless of market performance. This places a tremendous investment risk on the employer, as pension reserve returns are neither predictable nor guaranteed. Decades of low interest rates and stock market volatility left many pension plans unfunded.
Pension plans have inherent risks for employers, and societal changes have exacerbated them. Longer life expectancy extended the duration of each beneficiary’s retirement benefits. Continuous inflation introduced an additional variable. Few plans offered cost-of-living adjustments, and many pensions failed to keep pace with rising costs in the 1960s and 1970s. Congress eventually tried to restore confidence in the pension system.
Today’s retirement landscape can be largely traced to the Employee Retirement Income Security Act (ERISA) of 1974. Although Congress had long flirted with retirement reform, the collapse of several major pension funds it forced meaningful action. Among other provisions, ERISA guaranteed pension payments for struggling plans and established minimum participation standards. The bill also charged the Department of Labor with overseeing plans and enforcing ERISA requirements. Pension plans became more transparent, accountable and secure almost overnight.
Then, the 1970s saw the birth of a less publicized but equally influential innovation: the 401(k). Before ERISA, some companies allowed employees to defer earnings to a retirement account on a pre-tax basis. These accounts, called Cash or Deferred Arrangements (CODAs), attracted both employer intrigue and regulatory scrutiny. Growing curiosity finally forced Congress and the IRS to act. The Revenue Act of 1978 included a provision that formally allowed employees to defer income on a pre-tax basis. The IRS immediately codified the provision as Section 401(k) in the Internal Revenue Code. Suddenly, a cheaper, less mandatory and more flexible option became available to employers.
This seemingly minor provision prompted a cascade of changes. Business owners today enjoy an ever-expanding menu of retirement plan options. Employers can choose between pensions, conventional 401(k)s, and hybrids between the two. Other alternatives, such as stock bonus plans and ESOPs, allow employees to become owners in the sponsoring business. Simple retirement plans, such as SIMPLE IRAs and SEP IRAs, are available for entities pursuing simplicity. Finally, a number of nonqualified plans avoid burdensome regulations and benefit principals.
Choosing a plan
Retirement plans serve both employees and owners. For employees, these plans are tools that help ensure a comfortable future. For owners, employer-sponsored plans meet staffing goals, business objectives and personal ambitions. Unfortunately, choosing a plan can be challenging.
Our business planning experience shows that no two entities are alike. This is not surprising given the sheer volume of companies across the country. Over 5 million new businesses open in the United States each year. Behind each of these businesses lies a unique passion, vision and management philosophy. Plan selection requires a comprehensive review of business circumstances and priorities. Personalized guidance supports specific goals.
While businesses vary, a common theme prevails. Business owners want more time—a resource as finite as it is valuable. Daily tasks consume a significant portion of any owner’s week. Administrative duties leave little time for strategic planning. As a result, many entities have inadequate retirement plans or no plan at all.
Professional guidance is invaluable. An experienced team can identify the right plan for each organization. This leaves more time for owners to do what they do best: lead, create and grow.
Bryce Schuler is a financial advisor at BaldwinClarke in Bedford and is a certified financial planner specialized in business pension plans. This series of articles examines retirement plan options for various companies. Subsequent articles discuss key principles, compare plan options, and explore implementation strategies.