While pension plans are considered old fashioned by many, don't be too quick to dismiss them. For some small business owners, including dentists, pension plans are still a good choice.
The prevailing opinion among business owners and financial professionals is that pension plans, once a popular retirement vehicle for millions of Americans, aren’t just trending toward irrelevance. They’re an archaic tool and relic of bygone era that, much like the typewriter or printing press, are almost completely useless.The key drivers of this perspective are fairly well established, ranging from interest rates that have hovered near zero for more than seven years, to a lack of foresight that has led pension plans at the municipal, state, and corporate level, to become bloated, unwieldy, and nearly impossible to fully fund.
But even as pension plans probably should be discontinued in most circumstances, they shouldn’t be eliminated entirely. For a select group of small business owners, pension plans are still relevant, not only as an employee benefit, but as a broad financial planning tool that may help them significantly slash their near- and long-term tax burden. For a couple reasons, this is true for owners of dental practices.
For one, such practices are frequently mature businesses with consistent cash flow, headed by people whose income places them near or in the top marginal tax bracket. This is important because pension plan designs, per the Internal Revenue Service code, allow older business owners to defer a greater share of their income than other retirement plans.
For instance, an employer-sponsored defined contribution plan allows a business owner to defer up to $53,000. However, a pension plan permits the lessor of 100% of the participant’s average compensation in their highest consecutive three years, or $210,000.
That difference has the potential to deliver an enormous tax benefit, especially for high income earners. What’s more, it’s conceivable that over the course of several years a practice owner nearing retirement could fund enough to provide a maximum benefit for life. (Keep in mind that the exact number will vary from business to business, depending on a range of actuarial assumptions, including interest rate trends and the demographics of the plan participants).
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The most important caveat is that because pension plans establish a defined benefit, there are obligations for the owner that other retirement plans do not entail. That’s why this approach only works for well-established businesses with strong, consistent, and predictable cash flows. Otherwise, even business owners with healthy incomes are assuming too much risk, particularly if they haven’t fully retired other large outlays such as a child’s college tuition or their mortgage. They are responsible for covering any shortfalls should the plan become underfunded.
Second, dental groups often employ staffs that are considerably younger than the owner. The level at which business owners are required to fund a company pension plan is determined, in part, by the demographic makeup of their employees. In simple terms, the further away the plan participants are from the established retirement age, the less the business is required to contribute.
A young staff, therefore, creates a larger spread between what the business owner can save each year under the plan and their funding requirements. In some cases, that spread can be quite large. Ensuring business owners realize an economic benefit that easily offsets what they are legally required to put aside for their staff is typically the main consideration when deciding whether a pension plan is a good solution.
Meanwhile, there are other reasons to consider a pension plan beyond financial planning. In a world where some companies have scaled back or eliminated defined contribution plans like 401(k)s, pension plans can be positioned as an attractive, albeit increasingly uncommon benefit to young, top talent.
Also, the costs of setting up and maintaining pension plans aren’t as onerous as many assume. While it’s true the administrative fees are somewhat higher than other employer-sponsored options, they are also tax deductible business costs. Most importantly, over the life of the plan those fees are minimal when weighed against the full value of the business owner’s potential tax savings.
On a theoretical level, a defined benefit plan offers small business owners who run steadily growing and profitable enterprises an optimal way to maximize tax-deferred savings for long-term investment, beyond the limited thresholds of any 401(k) or other defined contribution plans. But practically speaking, because of the unique composition and character of many dental groups, it’s hard to think of a business type that is better suited for such an approach.
