We are often asked to design retirement plans for small businesses. In most cases, the primary objective is to provide the greatest possible benefit to the owner and other key employees while minimizing cost in terms of benefits to other employees. In recent years, cross-tested profit sharing plans have often been used to meet this objective. The purpose of this article, however, is to describe how a traditional defined benefit plan may be a better choice.

Cross-tested Profit Sharing Plan. Under a cross-tested profit sharing plan, contributions are allocated so that different “tiers” of employees receive different allocations. Contrast this with a traditional profit sharing plan that allocates contributions based upon relative compensation, possibly integrating such contribution with social security. The allocation must satisfy a non-discrimination test measured after taking into consideration each participant’s age. A typical cross-tested plan could be designed to provide the following allocations for a sample employer:

Employee	Age	Compensation	Cross-Tested Allocation	% of Current Compensation
Principal	55	$205,000	$41,000	20%
Associate	43	$60,000	$3,000	5%
Staffer 1	33	$35,000	$1,750	5%
Staffer 2	36	$30,000	$1,500	5%
Staffer 3	25	$25,000	$1,250	5%

While the cross-tested plan results in the principal receiving the bulk of contributions, the principal may want a greater retirement benefit than the profit sharing plan could provide. The only plan that would allow a larger benefit is a defined benefit plan.

Defined Benefit Plan. In a defined benefit plan, contributions are not limited to any specified amount. Rather, a participant’s retirement benefit is limited. A participant’s retirement benefit cannot exceed an annual benefit of $165,000 (indexed for cost-of-living) or 100% of final average compensation.

In designing the plan for the sample employer, the initial question would be to determine how great a retirement benefit the principal wanted to provide. For our purpose, assume the principal wants to provide the greatest permitted benefit.

The design of the plan can get complicated. A simple design for this situation would result in a formula that provides participants 8% of final average compensation multiplied by years of participation in the plan not in excess of 10 years. The principal will accumulate 10 years of participation by retirement age, 65. Thus, his retirement benefit will be 80% of final compensation (8% x 10 years). This will provide an annual retirement benefit of $165,000 (80% of $205,000). It is no coincidence that this equals the maximum permitted benefit.

Before a plan design can be finalized, its cost must be determined. A plan which requires contributions which far exceed that budgeted by the employer will not be successful.

The amount of the contribution is actuarially determined. While several funding methods exist to calculate the contribution, it can most simply be described as follows. The contribution for a plan year, together with existing plan assets, similar contributions for future plan years, and future earnings on plan investments must be sufficient to accumulate enough assets to fund participants’ benefits. Under our plan design, the calculation of the required contribution can be estimated as follows:

Employee	Age	Compensation	Annual Benefit at Retirement	Estimated Annual Contribution
Principal	55	$205,000	$165,000	$120,000
Associate	43	$60,000	$48,000	$12,250
Staffer 1	33	$35,000	$28,000	$3,175
Staffer 2	36	$30,000	$24,000	$3,425
Staffer 3	25	$25,000	$20,000	$1,250
			Total:	$140,100

The increased benefits provided under a defined benefit plan must be considered in light of the increased cost of establishing and maintaining the plan. The defined benefit plan discussed here would cost approximately $1,800 to establish and approximately $2,000 per year to administer.

Even more important than the increased cost, an employer considering a defined benefit plan must understand that the plan is a pension plan. Therefore, plan contributions are required, not discretionary. Thus, a defined benefit plan is not appropriate unless the employer is confident it will be able to make the contribution each year. In addition, the trustee of the plan invests plan assets. The investment return on plan assets will affect the employer’s required contribution in future years.

If the employer understands and accepts the complexities and increased cost of the defined benefit plan, the defined benefit plan provides the employer a tremendous retirement planning tool.