Demystifying Defined Benefit Plans: My Conversation with Nate Reineke of the Physician Family Financial Advisors Podcast
If you want the security of a guaranteed income during retirement, a defined benefit plan may be a good option for you. But how exactly does a defined benefit plan work, and who is it best for? Those are just some of the topics I discussed recently with Nate Reineke of the Physician Family Financial Advisors podcast. Defined benefit plans are very different from your typical 401k, and the concept can be difficult to grasp, but hopefully, Nate and I demystified the topic. Our conversation was geared towards Nate’s audience of physicians, but anyone in a similar situation can get some good takeaways. We hit both defined benefit and cash balance pension plans.
Quick take:
A defined benefit plan is a retirement plan that guarantees a specific benefit at retirement, typically based on a formula that considers factors like salary and years of service. An actuary must be involved to help determine how much needs to be set aside today to pay for future benefits.
This type of plan is a good fit for high-income self-employed individuals, business owners, and their spouses, who have a profitable business with sustainable cash flow and want more options for their retirement and tax benefits.
Not profitable or unpredictable cash flow? PASS on this plan!
Pros and cons of defined benefit plans
Pros: Guaranteed retirement income, Tax-deferred contributions
Cons: Complex and expensive to administer, Risk of the plan becoming underfunded, Less flexibility in investment choices
Things to consider before setting up a defined benefit plan
Get help from professionals: you’ll need an administrator, an actuary, and a financial advisor!
Weigh the costs (implicit and explicit) of setting up and administering the plan.
Be aware of the IRS and Department of Labor regulations.
Overall, defined benefit plans can be a good option for high-income earners looking for a guaranteed retirement income. However, they are complex and expensive to set up, so it is important to weigh the pros and cons carefully and get professional help before getting started.
Read on for the transcript of our conversation!
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Intro (00:00): This show is for educational purposes only and is not personalized advice. Consult your tax advisor before taking action. All investments involve risk of loss, past performances, no guarantee of future results. Reach show notes for full disclosure. Welcome to the Physician Family Financial Advisors podcast, where physician moms and dads like you can turn today's worries about taxes and investing into all the money you need for retirement and college.
Nate (00:26): Hello, physician moms and dads. I am Nate Reineke, certified financial planner and primary advisor here at Physician Family. We have a special guest joining me today on the show. Her name is Courtenay Shipley. Courtenay is the founder and Chief Planologist of Retirement Planology, a consulting and registered investment advisory firm for corporate sponsored retirement plans. So Courtenay is an accredited investment fiduciary, chartered retirement plan specialist, certified plan fiduciary advisor and certified exit planning advisor. What this means, all these letters behind her name, all the knowledge and all the experience she has, is going to help us accomplish our goal in this episode, which is to demystify defined benefit plans. Good morning, Courtenay.
Courtenay (01:16): Good morning and thank you so much for having me, Nate. It's great to be here.
Nate (01:20): You got it. Hey, I should check, is it morning for you? Where are you?
Courtenay (01:25): Oh, East coast. So just afternoon for me.
Nate (01:28): Okay. Podcasting through lunch. That's nice. Okay, so we're going to demystify defined benefit plans, but I have a question for you. First of all, you have a young child, is that right?
Courtenay (01:43): I do. I have a 6-year-old.
Nate (01:44): 6-year-old. Okay. Boy or girl?
Courtenay (01:46): Boy, boy.
Nate (01:47): 6-year-old boy. I have two boys, a 3-year-old and a five-year-old. So you're the perfect person to answer this question for me.
Courtenay (01:51): Okay.
Nate: (01:52): Okay, you ready? Okay. So my three-year-old was trying to go to bed last night and right as he was about to fall asleep, he popped up off his pillow and he had his little Snoopy stuffed animal in hand. And he looks at me totally very serious, and says, “Dad, do dogs have hands?” So my question is, do dogs have hands? I cannot think about defined benefit plans until I know the answer. I got to tell him…
Courtenay (02:25): I think dogs, dogs have paws, right?
Nate (02:28): That's right. That's what I told him. But he wasn't accepting the answer with Snoopy in hand. Well…
Courtenay (02:33): It's funny that you tell that story because when Max was a little bit younger than that, we were talking about different animals and different parts of the animal and whatnot, and I said, and dogs have a tail and monkeys have a tail. And then I looked at him, I said, “Do you have a tail?” And it was clear that he had never considered this before, and so he goes searching for his tail only to respond rather that he did not have a tail.
Nate (03:02): Yeah, well, I got a good laugh out of it, which spiraled out of control. Then he started asking questions about all his other stuffed animals. I was like, all right, dude, time to go to sleep. At least I have an answer about Snoopy for him now.
Courtenay (03:15): There you go.
Nate (03:16): Okay, so now we can move on because I have my answer. Demystifying defined benefit plans. This is an important topic, and many physicians I speak with, they just feel totally lost when it comes to defined benefit plans. They don't really get it. They know that it might be helpful. They don't know if it's right for them. So I want to focus mainly on the basics today explaining what they are, who might benefit from them, and I think we can give a good idea, maybe not exactly how to do it because that's your department and piecing all those pieces together, but maybe we can give people an idea on if they should even consider these.
Courtenay (03:56): Okay, so what is a defined benefit plan? Is that what I'm answering?
Nate (03:59): Yes, that's the first question. What is a defined benefit plan?
Courtenay (04:04): A defined benefit plan is a retirement plan that you are defining the benefit. You're defining the outcome down the road. When you hit retirement age and there's a formula, you have an actuary involved, you are going to figure out - or they're going to work with you to figure out - how much money to set aside today to pay that benefit that you're promising in the future. And so this could be a formula that is based on a percentage of your paycheck that's going to be paid to you in the future.
Something like, we're guaranteeing for every year of service that you have with us, we'll pay 45% or something along those lines of the average of your highest five years of pay or something along those lines. You have to work for us for 20 years before you get this. So there are strings attached. There's a very defined benefit that will happen at a future point and you are going to shove a bunch of money into a trust and that has to support that payout in the future, and an actuary is going to check your work each year to see if you have enough to fund that future benefit.
They have strict parameters on how that works and where you have to be within range for funding, and they're going to tell you at the end of the year, okay, this is what you need to deposit based on what you have in there and where we're going from here. Does that help?
Nate (05:30): That totally helps. Yeah. So essentially, I think the big takeaway for our listeners is going to be if you want a defined benefit, literally if you want to define your benefit, you can choose one of these plans. The hard part is that actuaries work so they earn their money. That's a complicated calculation. It's sort of like, how do I guarantee…this benefit that I have defined? How do I guarantee it? That's the actuary's work and that's difficult to do. So you have to engage an actuary. So obviously there are benefits to this and we're going to get into those benefits and everything, but could you tell me who is the right person for this - who actually ends up looking at opening a defined benefit plan where it works for them?
Courtenay (06:17): Well, usually the high income self-employed individuals, or owner and their spouse, or family businesses. Businesses that want to maximize their tax savings with large tax deferred contributions that are being set aside, those tend to be the ones who benefit the most. We've also seen it in other situations where they want to be very generous with their retirement benefits that they're offering their employees, too…
Nate (06:50): Right? Yeah. Because it is rather…the benefit's large. So another way to say that is it's expensive, right? It's expensive.
Courtenay (06:59): It's expensive. There's risk. Yes, because the business is on the hook for being able to fund this thing, and that is going to largely depend on the underlying investments. They're trying to manage those investments to a stated interest rate of some sort, and that's a moving target based on different actuarial parameters…
Nate (07:22): So, right.
Courtenay (07:23): Yeah, it's complicated.
Nate (07:24): Yes, it is. And I think, yeah, I think that's why people have so many questions. It's not so clear cut. The defined benefit seems reasonable for them to understand, but putting it into practice is tough. So a clarifying question. You said high income and I think…I don't know, that's another moving target. What would you consider an actually…a high income to make this worth it? Because it is complicated. There's a lot of moving parts. What amount of money does someone need to have available to make this worth it?
Courtenay (08:00): So if we're talking about compensation strictly, the maximum eligible compensation for 2024…so in other words, the amount that you make that could be considered for a plan like this, the top end is $345,000. So if you're making that or above, then I think that this would probably be a good thing to look at.
Another thing, though, is really, do you have a lot of profit coming from your business as well? And so if you have a too much cash and too many taxes problem, then this is the end of the line as far as the train goes, if you will, on all the stops along the way for different types of retirement plans where you can tax shelter money. We have finally gotten to the end of the line when you get to the defined benefit plan, because that's the one where you can put away the most, but you also have some parameters you have to consider.
Nate (08:57): Right. Okay. Where's the beginning of the line?
Courtenay (09:01): Oh, the beginning of the line is the straight up regular old 401k plan.
Nate (09:07): We all know about those. We do. Yeah. So, 401k plan, and what you mean by that is they're relatively simple to administer and you can't put a ton of money in them, at least compared to a defined benefit plan. So if you're not a really high income solo practitioner, you may just be fine with a 401k because you wouldn't save any more even if you had the option. Is that right?
Courtenay (09:33): Yeah, and it's important to note that there's a couple of different parts that go into a 401k. So you have what you as the employee can contribute, and for 2024, that's $23,000. If you are age 50 and up, you could do the catch up too, so you could do $30,500, but then there's this profit sharing contribution that can be put into the plan as well. And so it's kind of like a stair step, right? You put your money in and then the employer can put money in, and that goes up to $69,000. So instead of it just being the $23,000 that you're putting away, when you put in employer contributions, the maximum between those two is $69,000 and then you graduate maybe, and you take a look at either a cash balance pension plan or the defined benefit plan.
Nate (10:24): Right. Okay. So that's actually for people considering this, that's actually an interesting number, that 60 some odd thousand dollars. If you still have a bunch of extra money that you would love to put away for retirement and shelter from taxes, then maybe it is time to take a step up that ladder.
Courtenay (10:42): Exactly.
Nate (10:43): And it's complicated. Obviously, W2 employees don't have really a lot of control over this, but we're talking like, people who run their own practice or large organizations that are considering this for highly compensated employees. So if you are a physician who wants to save a lot more in taxes and wants to save a lot in taxes and also contribute a lot more toward your retirement, this could be super beneficial for you. But there's some questions, they're a little bit detailed questions that people will come to me and ask, so I want you to answer them for me. Okay. Make my job easier.
Courtenay (11:18): No problem. Okay.
Nate (11:18): Okay. So can a physician have a defined benefit plan alongside a 401k profit sharing plan?
Courtenay (11:26): Yes.
Nate (11:27): Okay. They can. Okay. Tell me a little bit about how that works.
Courtenay (11:31): Well, again, it's complicated. There's certain IRS criteria that you can't surpass. Your actuary and your third party administration firm are going to be the ones that you rely on to keep you out of trouble with all of that and make sure that you don't go above any annual limits for how much you can put away between plans.
Nate (11:56): Yeah, there's some extra rules when you're pairing these together, right?
Courtenay (11:59): Exactly.
Nate (12:00): Okay. So get your team all lined up because they all have a part in this puzzle.
Courtenay (12:06): They do. And you also want to work backwards from how you're trying to construct the puzzle. What is the outcome that you want? Because that will be very helpful in determining the plan type and then how you accomplish it between this ecosystem of plans that we've talked about.
Nate (12:24): Right. Okay, good. Is it the same deal with solo 401ks? Can you have both?
Courtenay (12:30): Yes. It's actually very easy to have a defined benefit plan if it's just you that you're covering. So that's from an administrative standpoint, very easy. It's when you start getting other employees involved that the cost goes up as far as how much you have to contribute to the plan as well.
Nate (12:49): Oh, I see. Okay. Yeah, I want to talk about costs in a minute. So you can pair these plans together. It is a bit complicated. You should certainly…well, you're required really to find professional help here, especially with the actuary. But I want to know, you talked a lot about the return. So the return in this account, you're aiming for a specific return, which sort of pushes you towards certain asset classes. Can you talk a little bit about how the money in this defined benefit plan should be invested?
Courtenay (13:23): Yes. I'm going to contrast it with the other plans we've talked about. Now we know in a 401k plan, that's you and the employer contributing money, and there's no defined benefit. It's just however much you put in. And then however you choose to invest it, there's a menu of investment options that you can pick from, and you get to combine those to make your own portfolio, and that outcome is completely on you as the investor. Then you move into the cash balance pension plan. This is a hybrid plan. It's very similar to a defined benefit, but it is actually just…it's not defining the outcome, it's only defining what is being put into it. So the cash balance plan is similar to the defined benefit plan in that we need a pot of money to support the amount that's going in, the contributions going in, and then we are also going to define how it grows.
So there's going to be some crediting interest rate that we assign to that. And so the pool of money underneath needs to support the contributions that went in as well as the annual crediting rate. So you can pick different things. You can talk with your actuary and you can decide, we want to keep up with treasury bills or we want to keep up with the market returns, et cetera. So that's going to drive what you have to use as the underlying investments. And so it could be as simple as a balanced portfolio. It could be a bond ladder, it could be…so there's some flexibility in how you want to pull that off. One of the pitfalls, though, is that you don't want to end up with a severely overfunded plan, or that could affect your ability to take those nice tax deferrals we were talking about before.
Now moving onto the defined benefit plan, now again, you are defining the outcome, so you are relying on that actuary to help with those future projections. That's where the market being very far down…let's say you have more of an equity allocation and the market's gone way down one year. Let's go back to 2010, 2009, 2008, somewhere in that timeframe. And you as the business owner are going to have to fund an underfunded pension maybe more than you thought you would. So that's why this is a little bit tricky as far as how you invest it.
Nate (15:43): Yes, that is very complicated in practice. I mean, it's complicated to understand, but the reality is it's actually complicated to achieve the return that you would like. I mean, if I could achieve the exact return that people ask me for…I wouldn't have time to be on this podcast. That's how busy I'd be. So it's a difficult thing and there are some problems if it's underfunded, especially, too, as far as, you got to come up with the cash to fill it up. This is difficult. And once again, I can't stress enough - get some help with these plans. I mean, they are not made for physicians to do on their own or kind of piece together on their own. So definitely get some help there. And the other big thing that I sort of wanted to touch on is, a lot of times because of those requirements, that you have to choose a rate that you're trying to keep up with, a lot of times what people feel most comfortable with is choosing a rate that isn't too large.
And so they end up choosing some investments in these plans that are rather conservative. And when you're trying to decide between which type of plan you're going to have, especially if it's just for yourself, young physicians…tend not to be comfortable with super conservative investments. They want some growth in there. So it's a give and take in these plans, and going over them with someone like you would be a really good idea to decide on if this is right for you. The big winners here are people who don't feel the need to be as aggressive and have a ton of cash in their business to save on taxes. Did I get that right?
Courtenay (17:31): And they don't need a lot of flexibility with what they do with that cash because once you sign on to one of these, either the cash balance pension plan or the defined benefit plan, you're kind of on the hook. You're going to have to make contributions. These are not short-term plans. The IRS expects you to have them open for a minimum of three to five years, or else they get a little upset if you terminate it early. And so that takes away your flexibility with how you use that cash. And depending on where you are in life…if you've got two kids you're trying to put through college or you want to invest in some new equipment to make the practice more efficient or offer something your competitors don’t, it does hamstring your ability to do those types of things if you're not careful.
Nate (18:15): Right. Yeah, careful is a big one in this department. So we are talking about permanency, investment choice, mandatory contributions. These are all things you should understand really well before signing up for one. Could you tell me a little bit about fees? What should people expect to pay for something like this?
Courtenay (18:35): Gosh, could be all over the map, right?
Nate (18:37): Yeah, definitely.
Courtenay (18:39): I would say that cash balance plans will probably end up, depending on how many employees that you have, somewhere between, let's call it two and $10,000 in administrative fees for defined benefit plans. Again, it's going to come back to how many people are we talking about that the plan covers, but it could be in the neighborhood of the same range.
Nate (19:02): So once again, if there's not enough tax breaks in this situation for you to make up for those fees, consider something else. But if you have a ton of money laying around and you're going to save way more than $10,000 in taxes by doing it, it could be right for you.
Courtenay (19:16): That's right.
Nate (19:17): Okay.
Courtenay (19:18): Don't forget too, with all of these plans, you're not just funding it for you. You also have to fund it for your employees. So there are…age comes into play, everyone's different salary or compensation also comes into play in determining those contribution numbers. And so it's very important that you have spoken with somebody and talked about the different demographics to get the total cost of the plan. It’s one thing to know how much you're saving. It's another thing to know how much you're having to spend in funding other people as well, that works for you in order to get that great tax break. Because as we know, the IRS gives you these nice things because you are also going to cover these other employees with it.
Nate (20:02): Right, right. That brings up a question I wasn't planning on asking, but I think that you'd be well-suited to answer. So we just talked about all the things that could go wrong, but what's the real driving force for these bigger hospitals or big groups that are considering these? Why do they do this? What's the benefit to all their employees?
Courtenay (20:24): Yeah, so there's really two. One, of course, is the tax issue, because this is a way for businesses to defer tax money. It's also a way to recruit and retain great people. Defined benefit plans have gone the way of the dodo. Most large corporations that have them have either frozen them or they're getting ready to terminate them. And so this would be special. It would be a special type of benefit to get some really good people in the door for you. Also, with things like the cash balance pension plan, you can put a three year vesting schedule on it. Perhaps they don't stay around long enough to get the contributions that the employer put in for them. And so you can take that back. Same thing goes with the profit sharing, but it's an attraction and retention tool, and that is why it gets a lot of play because it's a valued benefit, especially for your older demographic.
Nate (21:21): Yeah, I see this quite often when physicians are considering changing jobs as an employee. They look at their retirement benefits when they talk to us, and sometimes if they're on the fence, they'll just stay because the retirement benefits are so rich, and that can be good and bad. Sometimes we call those the golden handcuffs. But yeah, it is a good tool to use to retain great talent. So that's good. So imagine we have some listeners that really want to do this. When do they need to get their plans set up - by what date?
Courtenay (22:00): So we were talking earlier about this. There are some different targets. For example, right now it's the end of January. You could still set up a profit sharing only plan for 2023 for last year, and you have until you file your taxes in order to fund it. Now, that's one of the only ones that you could do retroactively. So anytime you're thinking about putting a plan in place, my rule of thumb is 90 days. That gives you enough time to talk through with all of your different consulting partners, talking with your actuary and your third party administrator, your investment advisor, and then also your tax accountant and have everything in place. And if you just go at this with, it's going to be 90 days before we pull any trigger, then you'll have enough time. If you want to start accruing benefits though, you have to get it done sooner than later so that you have the year to accrue the benefit and then fund it in the following year.
Nate (23:05): Okay. So what I'm hearing you say is they have some time this year to do it, but probably the best practice is to start as soon as possible. I know physician schedules pretty well, and they don't have a ton of time to be thinking about these kinds of things, so sooner rather than later, but we're at the beginning of the year, so you do have some time. Okay. I think that's everything. Now I'm going to ask you for the big takeaway. And I think that we gave a lot of detail. We tried to demystify the defined benefit plan, but at the same time it can still be confusing. What's the one thing our listeners should take away from our podcast today?
Courtenay (23:46): Well, to put it in medical terms, a prescription without a diagnosis is malpractice. So trying to go it alone on setting these types of plans up is not a good situation to put yourself in, just because they are complicated. The IRS and the Department of Labor both have purview over it, and you want to make sure that you get it right and that you lock in the flexibility that you need or the tax savings that you want.
Nate (24:15): Okay. And Courtenay, before I take us out, can you tell our listeners where they can find you if they're interested in setting one of these up or just have questions about how to get started?
Courtenay (24:25): Sure. They can go to retirementplanology.com, or you can find me on LinkedIn under “cshipley.”
Nate (24:34): Thank you so much, Courtenay, for being on today's episode.
Courtenay (24:37): Thank you, Nate. Thanks so much for having me.
Nate (24:39): You got it. Okay. That's all we have for today, and until next time, remember, you're not just making a living. You're making a life.
Extro (24:49): Thank you for listening to the Physician Family Financial Advisors podcast. Are you getting all the tax breaks you really deserve? To find out, get your copy of the Overtaxed Doctor's Retirement Investing checklist available at physicianfamily.com/go.