Retirement plans are fast becoming an important tool for small businesses to attract and retain talent. Surprising even some experts, it has joined the ranks of healthcare as a major employee demand, according to a new survey. More than ever, small business owners need financial advisors to help them find their way through the thicket of plans and regulations.

According to the Bank of America Merrill Lynch Workplace Benefits Report released in June, 66% of small business owners now say retirement benefits are important to attracting new talent, and 58% say they are important to driving loyalty. "A few years ago we'd have small business owners who wouldn't put this [issue] high on the list of things that attract and retain employees," says Rich Linton, head of Small Business Retirement for Bank of America Merrill Lynch. For years, the premium had been on healthcare, which, is still a top priority among job seekers.

But the real change is that small business owners are taking responsibility for making sure their employees are financially literate and able to plan their own financial futures, Linton says. In his 20 years in the retirement business, he has never seen such serious interest in employee retirement plans from small business owners. "That's an astonishing shift," he says. "Five years ago it was difficult to get business owners to engage in education beyond the basics of 'Here's your 401(k), here are your options, here's how the plan works,'" he says. Now they are asking financial advisors for help making their employees better savers and investors.

The downturn in 2008 and 2009 contributed to this shift, Linton says. Retirement benefits are not cheap to provide, so many employers want to be sure they and their employees are getting their money's worth. "Employers are asking their advisors to help with 'How do I make my employees more financially literate so they can optimize the benefits I'm providing?'"

Tom Foster, national spokesman for The Hartford's retirement business, says that small business owners often start from the wrong place. They assume they must put away a certain percentage for their own retirement, but don't really come up with a game plan for selecting a plan and funding it. "Once they figure out how much to allocate, then they should seek out expert advice from a financial advisor," Foster says.

Consider the case of a cardiac surgeon with two partners plus seven employees that Foster handled. The doctors had a profit sharing plan for years. The surgeon and his partners each saved $49,000 per year, and put away the matching percentage for his employees based on their salaries. After a while, the doctors' wealth accumulation slowed due to slumping markets. Foster helped them change the plan from a traditional 401(k) profit sharing plan to a strategy using "New Comparability Allocations." One requirement for this plan is this: If owners want to be able to contribute the full $49,000 for themselves, they must contribute a minimum of 5% of salary for each employee.

In addition, the surgeon and his partners added another retirement plan, called a "cash balance plan." This works for small business owners who are over age 45, have sustained profitability and are worried about taxes and accumulating enough to retire. If done properly, the business owner does not have to pay all of the employees additional money in the cash balance plan. After paying the employees 5% on the defined contribution plan, and then adding another 2.5% minimum on the cash balance side, the business owners only have to include 50 employees, or 40% of the employees, whichever is less.

In the case of the doctor and his partners, with 10 employees total, 40% equals four employees. The doctors opted to include the three partners, plus one employee. They chose the one who made the smallest salary, and whose contribution would cost the partners the least amount of money. "The beauty is I get to pick and choose," Foster says. There are so many different ways to allocate dollars, he says. "If I'm a younger business owner I might not look at plan design because I've got 30 years to fund the plan. Whether you're young or old there's a retirement plan to fit your needs, you just have to get the right advisors."

Experts agree that advisors must start by asking clients to answer a few basic questions. What is the primary goal of the business owner in starting the retirement plan? Is it to build a competitive benefits program to attract and keep employees, or to put money away for their own retirement? What is the budget for setting up a plan and contributing to it? What do the business owners need for themselves?

The first question divides the world of business owners into two camps: those who need to set up a plan for their business to take care of their own retirement, and those who want to set up the plan purely to help their employees, without regard to their own retirement.

Things are much easier if the business owner is in the second camp. This is because Internal Revenue Service rules are written to ensure fairness in retirement plans so that highly paid employees (including business owners) are not saving much more as a percentage of their salary than their lower-paid colleagues. This often results in a tug of war between finding ways to be fair to employees and allowing the business owners to save as much money as possible. This also explains much of the complicated architecture for retirement plans. Figuring out the best way to structure a plan so it serves both employer and employee is where financial advisors come in.

For owners who do not need the plan to fund their own retirement, there could still be many reasons why they cannot put much money into a retirement plan for their employees. They may not have much of a budget for funding a plan because much of their recruiting budget needs to be done through current compensation, or are unsure how much they can commit out of their own pocket. For them, a 401(k) plan is the easy choice, according to Lisa Germano, president and general counsel of Actuarial Benefits & Design Company, a Midlothian, Va.-based firm specializing in setting up retirement plans. She points out that employees can defer money on their own, just as they could if they had their own Individual Retirement Account. But in an IRA, the employee would be limited to a contribution of $5,000 this year, whereas in a 401(k) they can currently put away as much as $16,500. (The cap figures tend to increase every few years.) And if the business owner isn't deferring money from her own salary, she won't have to worry about making a comparable percentage match for employees.

Starter Retirement Plans

For the small business owners who don't have a big budget and need the retirement plan to help themselves as well as employees, advisors should consider starting small and growing into a bigger plan later. Ed O'Connor, head of the Retirement Services Group at Morgan Stanley Smith Barney, says that for these businesses a SIMPLE IRA (Savings Incentive Match Plan for Employees Individual Retirement Account) or a SEP IRA (Simplified Employee Pension Plan IRA) are the best bets. They are not qualified plans, like 401(k)s, and so are cheaper to set up and maintain; no complicated forms to file. They also do not have a lot of complicated rules about how much business owners must contribute to employees before their plan can get preferential tax treatment. But, the downside for owners is all contributions from employers are immediately vested. This differs from many sophisticated plans with provisions stopping employees from taking the employer match with them if they leave before a certain number of years.

The SIMPLE is an IRA for small business, and allows workers to defer up to $11,500 of their annual salary into the plan. Workers over age 50 can make an extra "catch-up" contribution of $2,500 a year. The employer can either match employee contributions 100% of the first 3% of salary, or contribute 2% of each employee's compensation. Because they are not qualified plans like 401(k)s, SIMPLE IRAs do not have a lot of rules to meet to get preferential tax treatment. But the amount of money that highly-paid employees, including the owners, can receive is much more limited than other plans. In short, it's a good starter plan, and can be outgrown when the business, and the budget for contributions, gets bigger.

The SEP is O'Connor's suggestion for a small business at the next stage of life with a small number of employees. It allows employers to contribute to traditional IRAs that are set up for employees. Only the employer contributes to a SEP, and he or she has the flexibility to decide whether to make contributions year-to-year. So if a year is looking like it might be thin, the employer can opt out of contributing, unlike many qualified plans, where the employer is more restricted.

When the company is bigger, it's time to move on to qualified plans. These include defined contribution plans, of which the 401(k) is the most famous, and defined benefit plans, also known as old-fashioned pensions. Qualified plans allows the employer to get tax advantages including deductions for contributions to the plan, and the growth is not taxable until the money gets withdrawn after the employee's—or owner's—retirement.

Things Get Complicated

Here is where small business owners start to run up against limits. In a traditional 401(k), the most that employees can contribute is currently $16,500 per year. Foster's advice for small business owners new to qualified retirement plans, but who want to increase that number, is to look at a profit sharing plan. In these plans, small business owners can contribute up to $49,000, or 100% of their salary, whichever is less (this salary figure is capped at $245,000 in 2010 and 2011 for purposes of calculating employee contributions in more complex plans). Employees and owners over age 50 can also put away an additional $5,500 a year to "catch up" on retirement savings. But, the trick is, the owner has to do the same for the employees. Sort of.

Whatever contribution the small business owner makes, he is required to make the same percentage contribution for his employees. If the maximum of $49,000 works out to 20% of the small business owner's income, then he must put away 20% of each employee's salary for that employee. This is also known as nondiscrimination, and plans must pass this IRS test to be in compliance.

Profit sharing plans also have more flexibility than other qualified plans. Foster notes that in the early years of a business, many business owners do not put away money for their own retirement, opting to pay back student loans, or putting money back into the business, thinking they will retire on the proceeds of selling their business.

When they find that's not the case, they hear about the $49,000 they can put away, and start a profit sharing plan. Then the owner often realizes he or she can't meet the financial burden and aren't able to put away as much for themselves as they'd like. Or maybe they can this year, but won't be able to next year. (Some qualified plans require employers to contribute the same amount every year, regardless of the profitability of their business.)

Profit sharing plans allow the owner the flexibility to contribute 20% for everyone this year, and drop the amount to 10% for everyone the next year. If executed cleverly, profit sharing plans can actually help employees get more cash for retirement, without costing the business owner a penny extra.

Germano helped a client do just that. A dentist came to her with a formula he used to give bonuses to his small staff. Each month he subtracted his expenses from his revenue and gave 80% of the net difference to himself and took the other 20% and divided it among his staff based on their years of service. He wanted that money to be deferred for retirement, not just more current compensation. Germano developed a profit sharing plan that met his needs.

By changing the payments from a bonus to an employer contribution to a profit sharing plan, both he and the employees saved on payroll taxes and the employees got that extra money in their accounts. "Everyone liked the employer making their retirement contribution based on that formula and it gave the incentive to work harder to reduce expenses and increase the net difference [between expenses and revenue,]" Germano wrote in an email.

Nondiscrimination Testing

Bells and whistles aren't always necessary. Even plain vanilla plans work well in the right circumstances. If the business owner wants to have to put out less cash while maximizing their own 401(k) contribution of $16,500, a traditional 401(k) could fill the bill. But there's a catch. In order for the business owner to set aside the full $16,500, she must know what percentage of her income that amount is, and if the employees will contribute a percentage of their own salary that's pretty close to it-generally, within 2%.

If the $16,500 equals, say, 6% of the employer's salary, the average amount set aside by the employees has to equal at least 4% or the plan flunks the actual deferral percentage (ADP) test. (Although specific dollar amounts can cause varying percentages, generally the gap can't be larger than 2%.) That means the employer has to take back money she contributed to the plan for herself. When Germano is working with a client to set up a plan, she surveys the employees first to get an idea of how much they are likely to contribute to avoid this problem.

A savvy advisor can sometimes see this kind of problem ahead of time, if she knows something about the business owner's industry. Some industries, like construction, tend to have lower salaries, and workers generally need most or all of their salary to live on, and will not likely allocate much at all to the retirement plan, Germano says. She and other experts note that professional firms, like engineers, doctors and lawyers are more likely to see employees contribute amounts large enough to pass the nondiscrimination test. But for the lower paying industries, a standard, stand-alone 401(k) will not likely work well if the business owner wants to maximize their own 401(k) savings.

Business owners in these industries are more likely to use a SIMPLE plan, or a Safe Harbor 401(k). The Safe Harbor 401(k) is just what it sounds like: a plan that allows business owners to make their maximum deferral and still get around a situation in which their plan would fail the nondiscrimination test. But they have to have enough skin in the game. An employer could make a 3% contribution on behalf of all employees, or match 100% on the first 3% of salary and 50% on the next 2%. That means the employer would contribute 4% of the first 5% of the employee's salaries. And, that's enough to pass the test. "But the bottom line is it's going to cost you to do that, and it's not cheap," Foster says.

There are other ways to encourage lower paid employees to keep contributing to the 401(k). One is automatic enrollment. Studies have shown if employees are signed up to have money automatically deducted from their paycheck for retirement, they are unlikely to stop the deductions. It doesn't cost the employer anything, but he is still taking a chance the employee might opt out.

A more active way to encourage employees to set aside money for their retirement, and raise the participation rates, is the "Saver's Credit," a little-known break from the government. It can reduce the amount of federal income tax paid by workers with incomes of less than $42,375 and couples with incomes of less than $56,500. The maximum amount of contributions taken into account to be eligible is $2,000 for an individual or $4,000 for a married couple. Many business owners, and even advisors, are unaware of the break, Foster says.

At the other end of the spectrum, the worry isn't that the employees will defer enough salary to allow the owners to max out their own contributions. The concern is having investment options that work for the employees. Rich Abrams, an advisor at UBS in New York City specializing in high-net-worth clients, recalls a law firm that cobbled together a menu of investment options. He was called in to help, and immediately noted that the plan did not have target-date mutual funds. "They were not paying attention to the fact that a lot of professionals are really busy," Abrams says. "If you have a lot of busy employees you've got to have a target-date fund. It's not that [as the plan administrator] we don't want to help and answer questions," he says, "but life is what happens when you're making other plans."


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