This is a legacy web site and some information may be out-of-date. For more recent information and postings, see www.tonynovak.com/cpa.


Tony Novak  800-609-0683
a passionate advocate for small business success

advice quoted in The Wall Street Journal and Money Magazine

Schedule a telephone consultation   

• Home 
•  Biography 
•  News 
•  Endorsements 
•  Services 
•  Publications 
•  Site Map

Investment strategies for a small business pension plan

By Tony Novak, MBA, MT, OnlineAdviser at FreedomBenefits.org

Those relatively few small businesses that use pension plans to provide tax-sheltered savings face unique opportunities and challenges in funding their investments and managing the investments. Since most small business pension plans are insured plans (also known as 412(i) plans) this article will focus on the investments available within the most popular types of annuity contracts.

Pension plan operators typically want to assume a low rate of return in order to maximize the tax-deductible contribution to the pension plan. The lower the rate of return, the higher the current tax deduction. In current markets, an annual rate of return below 4.0% is realistic given the low rates of return on guaranteed investments like CDs and fixed annuities. But over the long term, it makes sense to diversify into other types of investments with an expected annual return of 8%, 10% or more. The challenge is to make the transition in a way that will not create tax problems for the pension plan.

Start with the obvious choices

At the risk of sounding too simplistic, I suggest that pension plans should use the current market rate of the investment you choose in building the actuarial assumptions of the pension plan and then actually making the investment at that same rate of return. For example, if your bank is paying 4.2% on a fixed annuity this month, calculate your contribution based on 4.2% return and then deposit your contribution into that specific investment that pays a 4.2% rate of return. A surprising number of business owners calculate pension plan contributions assuming a 4.0% rate of return and then immediately purchase stock investments that are expected to yield more than 8.0%! This is just asking for trouble in the event of an audit. It is easy to move the money later to a higher-yielding investment, as discussed later in this article.

Follow a written investment policy

There is no requirement that the investments in a pension plan remain unchanged. The pension plan trustee, usually the business owner, may actively manage the investments in accordance with the plan' s investment policy. The trustee could modify the pension' s investment policy, for example, to allow stocks and bonds or even real estate. The investment policy is not required to be in writing but a smart business owner will insist on leaving a "paper trail" in the event of a tax audit. This type of formality in handling investment might seem silly in a one person pension plan but the payoff in additional stability and audit protection is worth the small amount of time it takes to keep written records. Many small business pension plans hire an investment adviser to actually carry out the day to day management once an investment strategy is in place. When it comes to handling pension plan investments, both professional managers and do-it-yourself investors should follow the same procedures.

Asset allocation 

An investment policy should detail the asset allocation strategy for the pension plan. In a one person pension plan, the allocation should also consider the individual' s assets outside of the pension plan. A newly self-employed person whose net worth consists primarily of stock in a high-flying former employer might wish to adapt a very conservative investment strategy within the pension plan in order to balance and stabilize her net worth. Many of the general investment principles that were used to manage investments over the past few decades no longer apply due to changes in the tax laws and the investment markets. Familiar formulas like "100 minus age = percentage of equity investments" simply do not make sense in a pension plan today.

Commission vs. no-load

It makes sense to decide in advance whether you will use traditional or no-load investments. For this discussion, accounts that include asset-based fees or "wrap fees" are considered the same impact as commissioned investments even though these are technically not commissions. The primary difference between commissioned vs. no-load investments is that service is presumed included with commission investments. You might need to hire hourly help separately with non-commission investments. No-load annuities tend to be about 0.5% to 1.0% less expensive than commissioned annuities. Accounts with balances less than $200,000 will find it cheaper to use commissioned investments than to hire advisers separately. Larger accounts with balances over $1 million will save money by using non-commissioned investments with one notable exception. Historically, the highest rates of return for fixed interest rate investments (fixed annuities, CDs, and guaranteed investment contracts) can be found with commissioned products. This investment niche is not served by the no-load financial community so it makes sense to use a regular commission product. Fortunately, today' s Internet services allow an investor or adviser to quickly search dozens of companies for the best current rates regardless of commission structure.

Ask to waive surrender fees

Annuity contracts typically have an early surrender charge during the first years of the investment. Most owners do not realize that Investment Advisers usually have the ability to request that annuity company waive the surrender fees if the pension plan is making a lateral move from one type of investment (a fixed annuity) to another type of investment (a variable annuity) within the same financial company. Some pension firms will even reimburse any surrender fees you might incur when moving money into their firm. Usually the only downside of making this type of investment switch is that you reset the clock to count a new surrender charge period.

Using variable annuities

Remember that most pension plans will want to keep funds invested in annuity contracts to avoid the higher costs of running an uninsured pension plan. The differences in overhead costs can be dramatic: insured plans cost about $650 but uninsured plans cost thousands of dollars more.

As a general rule, do an IRA rollover from a small business pension plan at the earliest opportunity for a wide range of reasons. This is a safer, easier and less expensive way to manage tax-deferred retirement funds.

Fortunately, today' s variable annuities offer dozens of attractive investment options. Variable annuity accounts resemble mutual funds. Many types of stock, bond, real estate and commodity investment choices are available. While annuities have higher operating expenses than mutual funds, the rates of return are comparable according to the numerous performance studies conducted over the past decade. This seems to defy logic at first until we factor in the higher portfolio turnover and trading costs associated with some mutual funds. Today' s variable annuities are a top-notch investment option, despite fees that are higher than some stock accounts and mutual funds. Unfortunately, some high profile financial writers do not agree. Well-respected financial publications have blasted variable annuities as being a poor investment choice due to the higher fees. Yet investors continue to flock to these accounts year after year due to the safety guarantees and popular account management features. Investors will continue to receive mixed messages about variable annuities. Each investor should evaluate their investment choices in light of their own performance objectives.

Use an IRA rollover

If you really want to widen the choice of investments, consider an IRA rollover. Funds can be rolled out of a pension plan tax-free into an IRA account and then managed in any way the account owner desires. A discussion of the methodology of pension plan terminations, distributions and rollovers is too involved for this article, but your adviser can provide specifics that apply to your situation. As a general rule, take advantage of the opportunity to do an IRA rollover from a small business pension plan for a wide range of reasons. This is a safer, easier and less expensive way to manage tax-deferred retirement funds.

Status: available for reprint

This article is available for republication in its entirety without charge after obtaining the express written permission of the author.

Please e-mail a request to the author that includes the name of the requestor (individual and corporate) and the intended destination of publication.