The changing environment for small business retirement plans: The five pillars

The Environment for Small Business Retirement Plans may have changed but they are more important than ever. Until a few years ago, most individuals counted on five pillars of retirement security: 1. Retirement Plans at Work 2. Pension Income 3. Personal Savings 4. Home Equity 5. Govt. Entitlement Programs However, a strange thing has happened on the way to Baby Boomer retirements: Four of the five pillars have started to look wobbly. Retirement plans are the only pillar that has stayed strong enough to support retirements through periods of economic changes. In this article, we will explain why it is more important than ever for Americans to save money systematically in retirement plans at work. What happened to the five pillars? Here is a progress report on each of the five pillars of retirement security. 1. Retirement plans at work. Retirement savings plans have continued to become more important to American's future financial security. According to the Investment Company Institute, the average 401(k) balance among workers with at least five years of participation increased from $67,585 in 2000 to $102,014 in 2005. Total assets in U.S. defined contribution plans doubled from $1.3 trillion in 1995 to $2.6 trillion in 2004. Over the same period, the same source indicated that total IRA assets increased from $1 trillion to $3.5 trillion. 2. Pensions. The number of U.S. private sector workers covered by defined benefit pension plans has steadily declined from 22.2 million in 1988 to 16.2 million in 2005. 3. Personal savings. Over the same decade that retirement plan assets have been growing steadily, Americans' personal savings habits have crumbled. The U.S. personal savings rate is reported monthly by the Bureau of Economic Analysis (BEA), and it represents personal income from all sources (wages, dividend and interest, employer retirement plan contributions and government benefits) less personal expenditures. Until about a decade ago, Americans consistently saved about 5-10% of their incomes. Then, in the late '90s, savings began to erode and in 2005 the personal savings rate even turned negatively for one quarter. From April 2005 through June of 2007, the U.S. personal savings rate has averaged less that 1% per year. It is important to note that retirement plan savings (including employer contributions) are included in the personal savings rate. As retirement plan balances keep rising while personal savings keep falling, it must mean huge erosion in U.S. savings outside retirement plans. How is this happening? A new dynamic has changed America household finances in the past decade and that is vast and increasing amounts of personal debt. Total Household Credit Market Debt Outstanding, a measure of consumer credit plus home mortgage balances, increased from about $5 trillion a decade ago to $13 trillion today, according to the Federal Reserve. Outside retirement plans, American's personal savings have not kept pace with their soaring debt and that poses a big problem for many Americans who are planning towards retirement. 4. Home equity. Home equity is another pillar upon which retirement security traditionally has rested, also is growing more fragile, according to an analysis by Bank of America Securities, the ratio of total U.S. home equity to home value (for people who have mortgage debt) has now declined to 35%, the lowest level in history. 5. Government entitlements. The fifth pillar consists of federal government entitlement programs, primarily Social Security and Medicare, both of which will require vast amounts of additional funding to remain solvent in the future. According to an analysis by USA Today, the cost of unfunded promises made by Medicare and Social Security together totaled $400,000 per U.S. household in 2007. Higher income retired people received a first taste of potential future cutbacks in these benefits this year, when their Medicare Part B premiums increased by up to 69% based on adjusted gross income. By 2009, when the income-relating provisions are fully phased-in, the Medicare Part B premiums of the highest income seniors will be more than double those of middle-income taxpayers according to The Senior Citizens League. Currently, high-income retired people pay income tax on up to 85% of their Social Security benefits, and there is some speculation that the income-relating concept eventually could be used to reduce the Social Security benefits of the affluent, as it has already increased their Medicare premiums. Retirement plans are the one pillar of retirement security that has continued to gain strength. Without the discipline of setting part of wages aside regularly in a tax-advantaged account, many Americans will face retirements in which economic resources are not adequate to support their accustomed lifestyles let alone retirement goals and dreams. Everyone should have a retirement plan savings discipline and most people should have enough money in these plans to fund at least 40% to 60% of their final working paychecks. The major types of qualified retirement plans and their current contribution limits are as follows: * Profit-sharing plan or 401(k): These plans are typically used by medium to large size companies. Annual filings and non-discrimination tests are required and participants can drive their own retirement savings with personal deferrals. For 2007, 401(k) deferrals are allowed up to $15,500 (plus an additional $5,000 for participants age 50 or older). Total annual contributions to all profit-sharing plans, including 401(k)'s many not exceed $45,000 in 2007. * Defined benefit plan: These plans permit very high contributions limits for older owners and key employees, but actuarial calculations are required to determine contributions, based on projected benefits. One form of this plan is the Fully Insured Plan, formally known as 412(i) Plan. Defined benefit plans require administration by qualified professional third party administrators. Annual contributions may be made to fund an annual payout of $180,000. * SEP-IRA: These plans are very easy for small business and self employed people to set up and maintain. They do not subject the employer to most testing and filing requirements. Contributions must be made for all eligible employees at the same percentage rate that contributions are made for the owner. For 2007, the maximum contribution is 25% of compensation (lower for self-employed people) to a dollar limit of $45,000. * Simple IRA: These plans are designed for small companies and they can be funded primarily with participant deferrals like a 401(k). Annual employer contributions are fully and immediately vested. For 2007, the maximum deferral is $10,500 and a catch up of $2,500 is allowed for those age 50 or over. * Traditional or Roth IRA: Traditional IRAs are funded with pre-tax contributions and Roth IRAs are funded with post-tax money (or by converting money in Traditional IRA). For 2007, the maximum combined contributions for IRAs are $4,000 and individuals age 50 or older may add an additional $1,000 catch-up contribution. Given that four of the five traditional pillars of retirement security are crumbling, virtually every U.S. business of any size should offer a qualified and/or non-qualified retirement plan to recruit, retain and reward its workers. There are many attractive choices for helping workers save systematically with tax advantages and the methods described in this article can help you focus on specific savings goals. There is one emerging new pillar of retirement security and that is having the support of a knowledgeable and motivational financial advisor who specializes in the small business retirement plan market. Dwight Moldenhauer, CLU, ChFC, is the owner of Moldenhauer Advisory Services, Buffalo, N.Y.