Not only do defined-benefit plans still exist, they are just the ticket for investors in particular situations.
I’m referring, of course, to the kind of retirement plan that used to be the most common way in which corporations funded their employees’ retirement. These plans, also known as pensions, guaranteed a certain level of payment during retirement.
Corporate defined-benefit plans fell out of favor a couple of decades ago, however, and few investors are even aware that they still exist. But they very much do, though now it’s up to us to set them up. And there can be huge tax advantages for doing so.
A personal defined-benefit plan provides a guaranteed payout in your retirement years, just like the defined-benefit plans of old. The yearly payout can be no larger than the average of your three highest-earning years, up to a maximum of $215,000. The amount you invest in your plan—which must be substantial to provide such a large guaranteed payout—is tax deductible.
Therein lies the major benefit of these personal defined-benefit plans. With a 401(k) plan, in contrast, the maximum amount you can invest tax-free each year is $18,000 (if you’re over 50, this amount increases to $24,000). With a defined-benefit plan, this maximum amount can be an order of magnitude larger.
The exact amount of this larger maximum is dependent on a number of assumptions, such as your age when you set up the plan, your income history, your life expectancy, and what actuarial assumptions are used to project stock and bond returns into the future. Charles Schwab, which can help clients set up these plans and then oversee and administer them, illustrated what this maximum would be by focusing on a hypothetical 55-year old in 2016 who intended to retire when he is 65, and whose income for the prior three years averaged $260,000 a year. The firm calculated that this hypothetical physician would have been able to contribute as much as $165,800 in pretax dollars into a personal defined-benefit plan.
To get early access to many more stories like this, subscribe to Retirement Weekly
That provides a huge tax benefit for someone who needs to fund his or her retirement in a big hurry and has the means to do so. Is there a catch?
Actually there are several, because of which personal defined-benefit plans aren’t for everyone. Here are the factors to keep in mind when deciding whether to even consider setting up such a plan:
•You must fund the plan annually. Each year an actuary must sign off on your plan, indicating how much additional you must contribute that year to keep your plan fully funded. You have no choice but to meet that commitment, or else face IRS fines and possible retroactive disallowance of the deductibility of contributions to the plan. You must be confident that you will have sufficient income in each of the years between when you set up a plan and when you retire to meet this annual commitment.
•Your requirement contribution will most likely mushroom during a bear market. Insofar as the investments in your defined-benefit plan fail to live up to what your actuary previously assumed, your annual commitment will have to be much larger still. This is especially worth remembering now, given that we very likely are in a low-return environment for both stocks and bonds. Research Affiliates, for example, the well-known investment firm founded by Robert Arnott, forecasts that the S&P 500 over the next decade will produce a return of just 2.5% annualized, while intermediate-term corporate bonds are projected to produce a return of just 2.7% annualized.
•High fees. Schwab, for example, charges $1,500 a year to set up, oversee and administer a personal defined-benefit plan with just one participant.
•You need to have a high and steady income. This requirement is because of the above three factors. Schwab, for one, estimates that “earnings, before considering the defined-benefit plan contribution, need to be $250,000 or more a year to make the cost of running the plan low relative to the tax savings.”
I mention these factors not to scare you away, but to emphasize that these personal defined-benefit plans aren’t for everyone. But since most investors in my experience aren’t even aware that they exist, chances are that some of you could benefit greatly from setting one up.
For more information, including descriptions of the Hulbert Sentiment Indices, go to The Hulbert Financial Digest or email email@example.com.