Defined Benefit Plans
In a defined benefit plan, the benefit is pre-defined, and the employer bears the investment risk.
A Defined Benefit plan is a retirement plan that promises a specific monthly benefit at retirement. The plan may state this promised benefit as an exact dollar amount, such as $100 per month at retirement. Or, more commonly, it may calculate a benefit through a plan formula that considers such factors as salary history and years of service, and in which the employer bears the investment risk. These plans are also known as “qualified benefit plans” or “non-qualified benefit plans”.
Traditionally, many governmental and public entities, as well as a large number of corporations, provided defined benefit plans, sometimes as a means of compensating workers in lieu of increased pay.
In the United States, Federal public sector plans are governed by the Tax Code and Federal law, while state and local public sector plans are governed by the Tax Code and state law. Thus the funding requirements, benefits, plan solvency, and participant rights and obligations vary greatly. Private sector plans are governed by the Employee Retirement Income Security Act of 1974 (ERISA).
These types of plans are best suited for individuals who are over the age of 50 and can commit to making a significant fixed contribution each year. The fixed amount, in this case, is the retirement benefit, not the contribution. Employer contributions are determined each year by market values of prior investments, how many years the employee has until retirement and other actuarial adjustments. (Contribution requirements are increased when the market does poorly and decreased when the market performs well.) Social Security is an example of a government-run Defined Benefit Plan. Learn maximizing Employee Benefits with Defined Benefit Plan and also for business to get a greater reduction in tax.
If an individual establishes a defined benefit plan, they can have other retirement plans. Businesses of any size may establish defined benefit plans, although they must annually file a Form 5500 with a Schedule B and have an enrolled actuary determine the funding levels and sign the Schedule B. Generally, the employer makes most contributions. Therefore, employers may need to dip into the company’s earnings in the event that the returns from the investments devoted to funding the employee’s retirement result in a funding shortfall. Sometimes, employee contributions are required or voluntary contributions may be permitted.
Single-employer plan or Multi-employer plan
A defined benefit plan can be either a single-employer plan or a multiemployer plan. A single-employer plan, which may be collectively bargained, provides benefits for workers of one employer. A multiemployer plan is a collectively bargained pension arrangement involving more than one unrelated employer, usually in a common industry, such as construction, trucking, textiles, and coal mining.
Some pros of these types of retirement plan are that substantial benefits can be accrued within a short time – even with early retirement, and are not dependent on asset returns. Also, defined benefit plans can’t retroactively decrease benefits and can permit participant loans, which is valued greatly at times. Individuals generally highly rate the fixed benefit provided by this type of plan, and on the employer side, businesses can generally contribute (and therefore deduct) more each year than in defined contribution plans. These plans can be used to promote certain business strategies by offering subsidized early retirement benefits.
Defined Benefit Plan with a Profit Sharing Plan
However, defined benefit plans are often more complex and, thus, more costly to establish and maintain than other types of plans. They are administratively complex and require more plan management than other types of plans. Lastly, an excise tax applies if the minimum contribution requirement is not satisfied or if excess contributions are made to the plan.
In some cases, the best option is to combine a Defined Benefit Plan with a Profit Sharing Plan. Your TRCO Consultant will work hard to ensure you can contribute as much as possible from year to year while managing your plan closely to avoid potential pitfalls such as over-funding and diminishing benefits.
WHO is an Ideal Plan Sponsor?
- Goal: Plan Sponsors looking to maximize personal retirement plan savings and achieve greater tax-efficiency than a defined contribution plan alone can provide.
- Demographic: These types of plans are best suited for individuals who are over the age of 50 and can commit to making a significant fixed contribution each year. These plan types can be applied to businesses of any size.
- Generosity: Employer contributions are determined each year by market values of prior investments, how many years the employee has until retirement, and other actuarial adjustments. (Contribution requirements are increased when the market does poorly and decreased when the market performs well.)
Support & Resources
We recognize that Defined Benefit Plan discussions can be complex. At The Ryding Company we simplify the process in two ways:
- Supporting Financial Advisors and Plan Sponsors in determining the suitability of this plan option.
- By creating easy-to-understand customized plan illustrations to explain the benefits and considerations of this plan type.
Cash Balance Plans Services
There are two general types of pension plans — defined benefit plans and defined contribution plans. Defined benefit plans provide a specific benefit at retirement for each qualified employee, while defined contribution plans specify the number of contributions to be made by the employer toward an employee’s retirement account
A cash-balance plan is a type defined benefit plan, but with a few elements that bear a resemblance to a defined contribution plan. Much like traditionally defined benefit plans, cash balance plans don’t invest any of the individual’s own money in the plan and they do not have any responsibility for the investment decisions. However, the difference between the two plans is that instead of the benefit in retirement is based on a formula that takes into consideration how long the individual worked for the company and their average salary during their last few years of employment, the cash-balance plan credits their account with a set percentage of their salary each year, typically 5%, plus a set interest rate that is applied to their balance.
The individual should receive an annual statement that shows the hypothetical value of their account, as well as what sort of monthly income payout (or lump sum) that will generate when they are of age to retire.
Differences between typical cash balance plans and 401(k) plans
There are four big differences between typical cash balance plans and 401(k) plans:
ParticipationParticipation in typical cash balance plans generally does not rely on the participants contributing a portion of their pay to the plan. Conversely, participation in a 401(k) plan does depend on an employee choosing to make a contribution to the plan, whether that is partially or entirely, it depends on the employee.
Investment RisksThe investments of cash balance plans are managed by the employer or an investment manager chosen by the employer. The employer then carries the risk of those investments. The benefit amount that is promised to individuals is not directly affected by increases and decreases in the value of the plan’s investments. Therefore, the investment risks are carried solely by the employer, not the individual. In a 401(k) plan, the actual amount of benefits provided to an employee depends on the amount of the contributions as well as the gains or losses of the account.
Life AnnuitiesCash balance plans are required to offer employees a choice as to whether they will receive their benefits in the form of lifetime annuities. 401(k) plans are not required to offer any type of annuity option for a distribution.
Federal GuaranteeBenefits in nearly all cash balance plans, just as most customary defined benefit plans, are protected by federal insurance provided through the Pension Benefit Guaranty Corporation, within certain limitations. Defined contribution plans, including 401(k) plans, are not insured by the PBGC.
Regarding plan design and administration, cash balance plans are generally preferred over a traditionally defined benefit solution. Of course, each situation needs to consider the details and circumstances as well as the objectives and desires of the client. We believe that larger firms with multiple owners/partners need a plan design that can meet the individual needs of each shareholder/partner without exposing them to cross-subsidization issues or greater liabilities associated with traditional DB plans. Your TRCO Consultant will work hard to ensure you can contribute as much as possible from year to year while managing your plan closely to avoid potential pitfalls such as over-funding and diminishing benefits.