Defined benefit plans are complex. Not only are they challenging for clients to understand, but many CPAs and financial advisors are also perplexed by them.
Most clients assume they work similarly to a defined compensation plan, like a 401(k). But that’s not the case.
In this post, we will talk about the top five ways defined benefit plans differ from defined contribution plans. Understanding these differences is critical. Let’s dive in!
Some Background
Defined contribution plans are relatively straightforward. Assuming you qualify, you can make an IRS-established maximum contribution in a given year. You take the tax deduction that year. Whatever you have funded will not impact subsequent years.
But defined benefit plans work very differently. These plans will define a benefit at retirement. This benefit is primarily determined by compensation and age.
Since this benefit is at a date many years in the future, the actuary has to ensure that your plan assets at the end of the plan year are adequate to cover the present value of the amount owed to the employees. Here is where the complexity lies.
Keep in mind that a defined benefit plan will specify a benefit amount at retirement. This benefit is calculated annually by the actuary.
Your annual contributions will vary depending on a lot of criteria. I will break it down for you.
#1 – No Set Contribution Amounts
Most clients are familiar with how solo 401(k) plans work. They can make IRS approved contributions assuming basic requirements are met. This gives client some certainty in their funding amounts.
But many people are surprised to know that define benefit plans have no set contribution amounts. The plans do establish generally large benefits that are accrued to employees. Because these benefits can be substantial, usually contributions will be large.
Plan funding is always a moving target, and we won’t know what your contribution will be until our actuaries run the final numbers. The reason behind this is that we have no idea what future investment returns will be, what your compensation will be, what IRS updates will be in place and what your desired final contribution will be. Essentially, we don’t have a crystal ball and there are too many unknowns.
#2 – Funding Range
You likely understand that your plan funding includes a target contribution and minimum and maximum amounts. But what do these figures signify, and why are they significant?
Target contribution. Your target contribution is the amount required to maintain your plan funding optimally. This ensures that the plan remains neither overfunded nor underfunded. For a target contribution, the actuary calculates a contribution amount to exactly meet the obligation. This target contribution is calculated each year based on add’l employee compensation and your actual investment performance.
Maximum contribution. While we usually recommend funding the target amount, the IRS allows contributions to exceed this target. How is the maximum contribution determined? The IRS permits you to contribute up to 150% of the accrued amount and cover the full benefit increases for the upcoming year. This allows for a higher funding amount; however, it does not change the defined benefit. Consequently, future contributions may decrease unless the defined benefit is increased.
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Minimum contribution. Due to overfunding in previous years or increased asset returns, your minimum contribution may fall below the target level. Most plans require mandatory funding. However, due to aggressive funding, the actuary may determine that additional funding is unnecessary to keep your plan on track.
#3 – Prior Contributions Impact Future Contributions
Defined benefit plans are a permanent ongoing plan design. So, contributions made in one year will impact future years. This is because we’re trying to build a defined “benefit” at retirement. For this reason, we have one saying that we like to use with clients:
Every dollar you contribute to a plan today is one less dollar that you can contribute in the future.
That is an important concept to understand. Very often clients will come to us looking for a frontloaded plan where large contributions are made in the first year. While we try to educate them, many clients things that can make a large contribution in. This is simply not the case.
Remember that plans are not define contribution plans. Because are contributions funding in can occur in different periods of time and there is such thing as a contribution amount.
#4 – Investment Returns Impact Future Contributions
Investment gains and losses will affect future funding. That’s why it is imperative that clients grasp how investments work with defined benefit plans and defined contribution plans.
Significant investment swings do not impact defined contribution plan contributions, but they can have a huge impact on defined benefit plans. This is because the future benefit amount can be reached through either contributions or asset returns. But that’s not the case for defined benefit plans.
Is a Cash Balance or Defined Benefit Plan Right For You?
Once you deposit the funds into a defined contribution plan, it doesn’t matter if the assets go up or down because the limits are established upfront. The investment returns have no impact on future funding.
For example, suppose you contribute $40,000 into a 401(k) plan. If the value of the investments grew to $80,000 the following year because you chose top-performing stocks, this growth will not affect future plan contributions. In addition, if you invested in stocks that lost all their value, this would also not impact your future contributions. This is because the contribution amount is “defined” each year.
Most plans have an implied interest rate of around 5%. If investment returns exceed the actuarial interest rate, contributions will decrease. This is because a higher asset balance means lower contributions are required to achieve the same benefit at retirement.
If the actual investment returns fall short of the actuarial rate, the actuary will require higher contributions to the plan. In other words, if asset returns are lower than expected, the plan owner will need to contribute more to ensure they remain on track to fulfill the future benefit.
Using the example mentioned earlier, if the $40,000 contribution doubles to $80,000, the actuary will decrease the contribution for the following year. This adjustment occurs because the actuary has estimated a return of approximately 5%, and since the actual return is 100%, the contribution will be lowered to align with the projected future benefit.
Once you understand how investment gains and losses impact your plans, you can make better investment choices. At the end of the day, your conservative investments should be in the defined benefit plan and the aggressive assets should be in your 401(k) plan.
Final Thoughts
In summary, while both defined benefit and defined contribution plans offer valuable retirement savings opportunities, they differ significantly in structure, risk, and predictability. Choosing the right plan depends largely on the goals and resources of the employer, as well as the needs of the business owner.
Ultimately, both types of plans play a crucial role in today’s retirement landscape. As pensions become less common and personal responsibility for retirement savings increases, individuals must be more proactive in understanding their plan options. Likewise, employers must thoughtfully design their offerings to meet business objectives while supporting the financial well-being of their employees.
