Pension Tension: tax-efficient, diversification strategies for small-business owners.

• Author: Bennett, Daniel R.
• Position: Financial planning

A common belief we hear in the business community is that the good old-fashioned defined benefit plan is disappearing-or gone. While this may be somewhat true for the large corporate plans, it's hardly the case for small, privately held companies. A well-designed defined benefit plan is state-of-the-art tax and financial planning for the small-business owner and provides for other key benefits beyond immediate tax relief that often go overlooked.

Small-business Vulnerability

Successful business owners are rightly concerned about growing their businesses. However, this singular focus on growing the business does carry some risk.

First, day-to-day effort of running a business often leaves lithe time for planning. Second, the success of the business may actually dissuade the owner from diversifying the source of wealth creation away from the business. A high asset concentration runs counter to modern portfolio theory's prescription for diversification and exposes the owner to the real risks to business value, including dependence on a departing owner, technology changes, industry shifts, demographic changes, litigation and partner disputes.

We mention these because they can, and often do, arise at the most inappropriate times, more often when an owner is looking to liquidate.

Defined Contribution Plans

The solution to this vulnerability is preparation and planning. One of the most effective strategies to address this vulnerability is pension planning, and particularly the use of defined benefit pension plans. As mentioned, only a minority of owners sponsor a qualified plan, and of those who do, typically the choice is for some type of defined contribution plan, like a Simplified Employee Pension or 401(k) plan.

However, defined contribution plans have major drawbacks for the owners.

First, as measured by the percent of contribution going to principals, the plan typically will max out at 30 percent to 35 percent. That's because, by nature, such plans are capped in absolute dollar terms and in relation to employee pay, which typically fixes heavy constraints on what the owners and other highly compensated employees can do.

Second, when measured against replacement of income, the 401(k) plan--because of these contribution constraints--will typically only replace 10 percent to 20 percent of the owner's income, even assuming a robust growth rate. Meanwhile, average employees, if they fully utilizes the plan, may see 30 percent to 50 percent of...