Higher income

Defined benefit plans, the option most owners never hear about

You have maxed everything else. The contributions went in, the deductions were taken, and there is still income sitting there that you would rather not take this year.

This is the point at which an owner usually asks whether that is simply it. The familiar accounts have limits, the limits have been used, and everything else on offer feels like a rounding error against the size of the income.

There is another category, and most owners have never had it explained to them. It is not obscure and it is not aggressive. It is just administratively heavier than the plans people meet first, so it rarely comes up unless somebody raises it deliberately.

The misconception

That these are only for large employers. The mental picture is a pension at a company with thousands of staff, a scheme somebody's parent retired on, something belonging to a different era of employment.

The structure is the same. The scale is not fixed. A plan of this kind can be established by a very small business, including one with a single owner and no other employees, and the small case is often where it fits best.

How it works

The plans most people know work forwards. You decide what to put in, within a limit, and whatever it grows to is what you end up with. The amount going in is the fixed part.

A defined benefit plan works the other way round. It promises a future benefit, a stated amount payable in retirement, and then calculates backwards to what has to be contributed now to be on track to deliver it. The benefit is the fixed part and the contribution is the output.

Everything else asks how much you want to put in. This one asks what you are promising, and then tells you what it costs.

That reversal is why the amounts can be far larger than the alternatives. If the promise is meaningful and the years remaining to fund it are few, the arithmetic demands a large contribution, and the contribution is deductible to the business within the plan's rules.

It is also why age drives the answer so strongly. Two owners with identical income, one in their late thirties and one in their late fifties, arrive at very different numbers, because one has decades to fund the promise and the other has years.

The number

As a range, contributions under these plans commonly run several times what the more familiar options allow, and for an older owner with high and stable income the figure can be a multiple of that again. It depends heavily on age, on the income the benefit is calculated from, on how many years remain to normal retirement age under the plan, and on what other plans exist alongside it.

Older owners can generally contribute more, for the reason above. That is the single largest driver in most calculations.

The maximum benefit these plans can promise, and the compensation that can be taken into account in calculating it, are set annually and adjusted. Any number you are given belongs to a specific year and should be confirmed for the year you are planning.

What this requires

• An actuary. The contribution is a calculated figure, not a number you select, and it has to be certified.
• An annual valuation, every year, with a cost attached whether the year was strong or weak.
• A real multi-year commitment. These plans are designed to be funded over time, not opened for one good year.
• The discipline to fund it in a bad year too, because the obligation does not pause when revenue does.

The running cost is genuine and should be quoted before anything is signed. It is not large relative to the contributions in a well suited case, and it is very large relative to the benefit in a poorly suited one.

If there are employees who qualify, they may have to be covered, and the cost of covering them forms part of the decision in the same way it does for any other plan.

Who this is not for

This is the important section, and it is longer than the rest for a reason. The failure mode here is expensive.

Businesses without consistently high and stable income. The commitment is the defining feature. A plan adopted on the back of one exceptional year, in a business where the following year might be half of it, creates an obligation that has to be met out of a smaller figure. Unwinding it is possible and it is neither quick nor free.

Owners who may want to stop in two years. Terminating a plan shortly after establishing it invites scrutiny of whether it was ever intended to be permanent, and it wastes the setup cost. If the exit is close, the useful planning is about the exit, not about opening a long term structure in front of it.

Anyone who has not yet used the simpler options. Work up the ladder. If the ordinary plans are not full, the question of whether you need this one has not arrived yet.

And anyone who wants access to the money. Funds in the plan are for the promised benefit. This is not a place to park cash you might want back.

When this happens

The plan has to be established before a deadline, and funded on a schedule after that. Both dates matter, they are not the same date, and neither of them is the day you file.

In practice this means the decision belongs in the second half of the year, while the income picture is becoming clear and there is still time for the actuary, the documents and the adoption to happen in order.

The point

For an owner with high, stable income, no easy way to reduce it, and a real intention to keep going for years, this is frequently the largest single planning move available. For everyone else it is a commitment that costs more than it returns.

Which of those you are is a planning question, decided during the year with the projection in front of you. Your Charter team works through the suitability before anybody talks to an actuary.

This is general information, not advice on your own situation. Whether any of it applies to you depends on facts this article does not know.