Here we will give a brief overview for a concept which candidly isn’t workable very often. But when the planets align, it can yield substantial results.
A long time ago, most retirement plans were of the type known as defined benefit (DB) plans. This term means that what the retiree is ultimately going to get is determined at the outset. Social security and most pension plans for public workers, union members and the like are of this type. These fell out of favor many decades ago for the simple reason that they can be incredibly expensive to fund. The ones we still see now are, for the most part, ones left over from that past era.
Most new plans follow the defined contribution approach, in which a certain amount is put back, but no measurement of future outcomes is made. This essentially transfers the investment risk to the employee, away from the company. Cheaper and less risky are two big reasons for an employer to move away from DB plans; and over time they have.
So you don’t see too many new DB plans these days. But you do see a few, and they often share a common set of facts:
- Profitable business or professional practice
- Owned by someone who is older than 50
- Relatively small staff, who on average are younger than the owner and not as highly compensated.
If this set of facts is present, then consideration of a DB plan becomes much more important. The details are pretty involved, but the idea basically takes advantage of the fact that if you have to create a large pension payout (as for a highly compensated person), and you don’t have many years left before the person retires (maybe just 5 or 10), then you are going to have to put back a lot of money every year to hit the goal.
When properly structured, pension contributions are tax deductible when made, and grow tax-deferred until paid out in retirement. So especially in high income cases where the owner doesn’t really need all the money right now in the first place (i.e. the monthly household budget is a lot less than the monthly income), a DB plan can open the door to moving the surplus out of taxable income and into savings.
This is of course what happens with normal IRA and 401(k) contributions, but in a DB case the limits on what you can contribute and deduct may be much higher (e.g. $100,000 per year, or more). Remember, the goal for a DB plan is to fund a specified level of future income. Without the higher contribution amounts it might not be possible to meet the pension projections, so the usual limits on contributions may go away.
Again, this strategy needs a pretty specific set of conditions to work well. But if those conditions are present, it can be one of the most significant ways there is for deferring current income and creating truly substantial growth in money which is being set aside for use in retirement. It takes a specialized team to assess and then create one of these plans, but when the tax savings can run into the six-figure range, the effort could be well worth the benefit.