You may have heard of the benefits of defined benefit pension plans. But what are they and how do they work? Also, do you really understand the rules and the formula?
Before establishing a DB plan, you must understand how to structure one and carefully analyze the pitfalls and benefits. Then you should have an administrator run an illustration. First, we’ll provide a quick summary and then we can dive into the details.
Defined benefit plan rules summary:
The annual participant benefit under a defined benefit pension may not exceed the lower of:
- 100% of the employee’s average W2 compensation for their highest 3 consecutive years; or
- $265,000 for plan year 2023 ($230,000 for 2021 and $245,000 for 2022)
In this post, we will cover the plan basics. We have a couple videos that will explain the cost and eligibility requirements. Let’s dive in!
Table of contents
- What is a defined benefit plan?
- Who is a defined benefit plan best for?
- What are the pros and cons?
- Is there such thing as an owner-only defined benefit plan?
- Owner-only plan illustration
- Rules for owner-only plans
- What if I have employees?
- Defined benefit plan illustration
- What about IRS rules?
- How to Set Up a DB Plan
- What about the formula?
- What about investments?
- Final Thoughts on DB Plans
What is a defined benefit plan?
The term DB plan is just short for defined benefit plan. Defined benefit plans promise a specific benefit after retirement for each of the employees. The term “defined” is used because the plan uses a benefit formula that is known in advance.
A DB plan works a little differently than your typical 401k plan. With a 401k plan the IRS limits the amount that you can put in up front. Currently this limit is $57,000 annually.
But a DB plan allows for much larger contributions. This is because the plans are looking to provide a specific benefit at retirement. As such, you can make larger contributions today to reach your retirement goal down the road.
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You can think of it like a turbo charged 401k plan. Annual retirement contributions are often greater than $100,000 and we have many clients who contribute over $300,000 annually. The plans are more complex to administer but are great for high income business owners.
We have discussed the fact that DB plans allow for much larger contributions compared to 401k plans. This is true.
But the size differential widens as people get older. The reason is that the closer they get to retirement, the more the plan will allow to reach that end retirement goal.
Who is a defined benefit plan best for?
A defined benefit plan provides a specified amount of retirement income to the plan participant, typically based on a formula that considers the participant’s years of service and earnings history.
Defined benefit plans are generally considered best for individuals who:
- Are looking for a predictable and stable source of retirement income: Unlike defined contribution plans, such as 401(k) plans, where the retirement income is based on the performance of the investments, the retirement income from a defined benefit plan is guaranteed and predictable.
- Have a long-term employment relationship: Defined benefit plans are often associated with traditional, long-term employment relationships and are most commonly offered by government entities and large corporations. A defined benefit plan could be a good option if you plan to stay with your employer for a long time.
- Are risk-averse: Defined benefit plans are generally considered to be less risky than defined contribution plans because the investment risk is borne by the plan sponsor, not the plan participant. This can be especially attractive for risk-averse individuals with a low tolerance for investment risk.
- Have a high income: Because defined benefit plans typically provide a guaranteed retirement income based on a formula that considers the participant’s years of service and earnings history, they can be especially beneficial for individuals with a high income.
- Are close to retirement age: Defined benefit plans are often structured to provide a higher retirement benefit the closer the participant is to retirement age. If you are close to retirement age, a defined benefit plan may provide a higher retirement income than a defined contribution plan.
What are the pros and cons?
DB plans are what is called a “qualified” plan. This basically means they qualify for a tax deduction or tax deferral. When you contribute to the plan you get an immediate tax deduction, but are subject to taxation when you take the funds out at retirement. Let’s point out a few other benefits:
- Plans are not subject to the $57,000 contribution limits that come with defined contribution plans (like a 401k).
- Qualified plans are generally afforded lawsuit and bankruptcy protection.
- They work for all types of entities. This includes sole proprietors, S-corps, C-corps and partnerships.
- They can be combined with other retirement plans like a 401k, profit sharing plan or even a traditional IRA.
- Solo DB plans can utilize a a Mega Backdoor Roth to supercharge contributions.
- They allow what is called portability. When an employee leaves a company, they are allowed to take their vested account balance to another retirement plan or even roll it into an IRA.
- Any contributions become tax deductible.
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But there are a few other things that should be considered before you set up a plan:
- The plans are actually “permanent.” This really means that you have to have them open for at least several years. But you are allowed to terminate the plan for reasonable cause.
- Contributions are typically not elective like 401ks or other defined contribution plans.
- An actuary is required to review and certify the plan every year. This is to make sure the funding is able to pay future retirement payments.
- They are more costly to set up and administer. Typical plans will run at least $2,000 to annually administer.
- The plans often have restrictions on any lump sum payment.
Is there such thing as an owner-only defined benefit plan?
Defined benefit plans can be set up as owner-only plans. In fact, probably over half of our plans are what you would call “solo” plans. Many clients also do a Mega Backdoor Roth.
How do the plans work? Generally, a defined benefit plan attempts to specify benefit levels for employees. Once benefit levels are established, contributions are determined based on actuarial calculations. The employer assumes the investment risk used by the employee benefit trust that administers the plan’s assets.
If the investment returns cause the plan assets to fall below the amount actuarially necessary to pay the defined benefits, then the employer must make additional contributions. Thus, defined benefit plans are subject to the minimum funding requirements under ERISA, whereas those rules have little meaning for defined contribution plans.
Owner-only plan illustration
In such a plan, income over the forecast levels benefits the employer by reducing future contributions (§412(b)(3)). Although contributions may vary based on the investment program, such plans are a fixed obligation of the corporation, and contributions must be made annually to the plan regardless of the company’s profits.
The primary form of the defined benefit plan is the defined benefit pension plan. A defined benefit pension plan must provide the payment of definitely determinable benefits to the employees over the years after retirement. In short, it guarantees a monthly income for a participant at retirement age.
Benefits are measured by years of service with the employer, years of participation in the plan, percent of average compensation, or a combination thereof. In addition, most defined benefit pension plans pay Pension Benefit Guaranty Corporation premiums to ensure that participants’ guaranteed benefits will always be paid at retirement.
Rules for owner-only plans
Plan design is a process by which the plan sponsor ensures that the retirement plan will meet the business’ goals and objectives for retirement savings, employee retention and tax efficiency.
For example, for a company whose critical employees (i.e., owners, officers, key management, etc.) are older than the majority of the employees, a defined benefit plan may make the most sense because it is possible for the critical employees to accumulate a much larger benefit over a shorter period of time than could ever be accomplished in a defined contribution plan.
A defined contribution plan is limited in the amount of contribution a plan sponsor can allocate to each employee. Due to this contribution limitation and the age of the employees, there may not be sufficient time to accumulate the desired retirement benefit using a defined contribution plan.
Since benefits are limited in a defined benefit plan but contributions are not, and the amount contributed is determined actuarially to accumulate to the desired benefit, a defined benefit plan allows for accumulation of sufficient funds for retirement in a short period of time. This is especially true for older participants.
|Defined Benefit Plan Features ✅||401(k) Features|
|Tax-Deferred Contributions ✅||Elective Contributions|
|Maximum Funding Range||Low Administration Fees|
|$100k Plus Contributions||No Actuary Review|
|High Set Up Fees||Easy Set Up|
In plan design, the type of formula considered should be based on how the plan sponsor wishes to benefit certain groups of individuals. If it is important to the plan sponsor to favor employees with long service, then a unit benefit plan may be best. If the plan sponsor wishes to favor employees based on compensation level, then the formula should use a percentage of pay instead of a flat dollar amount. An administrator can provide a defined benefit plan illustration to show multiple contribution levels.
The plan sponsor should also consider the amount of money it can afford to contribute to a plan each year. A high dollar amount or percentage of pay formula may require a greater contribution than the plan sponsor can afford. Thus, the plan formula should be designed with a budget in mind. The IRS requires that a plan be “permanent” and not just a temporary tax structure.
Although plans can be terminated for valid business necessity, the sponsor should plan on maintaining a plan for many years since the IRS expects plans to satisfy a “permanency” standard. This standard usually includes a minimum number of years that the plan is in effect. Although not officially defined, the minimum years often is cited as three to five years.
What if I have employees?
There is no doubt that these plans work best for solo business owners or professionals. If you have eligible employees you will be required to make a contribution for them. But there are ways to limit your exposure.
As a guide, the employer can exclude part time employees and certain other employees, but will need to make a contribution of approximately 5 to 7% for remaining employees in order to pass the rules.
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Employee contributions are usually not that significant at the end of the day. Our goal is to get 85% to 90% of the contributions for the business owner. This is not always possible if the owner has substantial high income and older employees. But that is at least the goal.
Defined benefit plan illustration
IRS assumes supervisory activities of pension plans. The rules and regulations have helped avoid abuse of privileges granted to pension plans.
One very important rule is “non-discrimination.” It verifies that a plan does not favor highly compensated employees. The regulations have favored DB plans and have encouraged employers and employees to increase their retirement savings. However, the IRS and the Department of Labor have strict compliance standards you will see on the illustration.
The investments will grow tax-deferred once the company has contributed to the plan. Benefits from defined benefit pension plans are received at retirement or earlier and are subject to federal and state personal income taxation.
The employer can exclude part-time employees and certain other employees but must contribute approximately 5 to 7% for the remaining employees to pass the rules. Employees receive annual contributions from the employer.
The plan gets pre-determined additional contributions on the employer’s part based on the amount contributed as a percentage of the employee’s salary. So the requirements aren’t that difficult.
What about IRS rules?
Under defined benefit plan rules, employees or participants receive vested accrued benefits earned to date. The benefits should be received no later than the 60th day after the plan year’s end when they have been employed for ten years or decide to leave a job.
When an employee leaves the job, the benefits earned to date are frozen and held in trust until retirement age if they don’t choose to take a lump sum or rollover to another pension plan.
Benefits in a defined benefit plan are distributed through life annuities. The participant receives monthly, quarterly, or annual benefit payments for the rest of their lives. One begins receiving the benefit not later than April 1 of the next calendar year following the year of retirement or following the year an employee attains seventy and a half years, whichever is later.
A participant’s spouse can receive a 50% benefit because a defined benefit plan allows for joint distributions. Once employers and employees have contributed to a defined benefit plan, they invest assets to grow their funds and the earnings from these investments are not taxed.
Benefits from a defined benefit pension plan are received at retirement or earlier and are subject to federal and state personal income taxation. A participant also recovers the amounts that have previously been taxed.
How to Set Up a DB Plan
Here are 5 steps to follow when setting up a DB plan:
- Determine how much you want to fund in the current year
Maybe you had a large windfall in the current year so maxing out the plan might make sense. Even if it limits future contributions. Plans can be “front loaded” by including a prior service opening credit. But remember that every dollar contributed today is one dollar less that you can contribute in the future.
- Consider future funding levels
You might choose to stay well below the limit because you anticipate being in a higher tax bracket in future years and you want to make sure that you do not overfund. As such, you could consider straight line contributions or simply fund at the targeted level or in the middle of the range.
- Have a TPA run an illustration
You want a defined benefit plan illustration completed that will show you the current year funding and confirm your cash requirement. Most administrators can run multiple scenarios based on different compensation levels and funding goals. They can also be run for larger plans with employees. The goal is a contribution of at least 85% of the contribution going to the owner.
- Consider a 401k combo
If the DB contribution is limited, you can consider the combining the plan with a 401k to improve funding levels. In fact, over 90% of our plans are combo designed and tested. The business owner is then able to get a larger contribution with minimal additional administrative fees.
- Make sure you don’t exceed the defined benefit limits
Your TPA can work with you to make sure that you do not exceed the legal limit. Benefits in a DB plan are distributed through life annuities. A participant receives monthly, quarterly, or annual benefit payments for the rest of their lives. A participant’s spouse can receive a 50% benefit because a DB plan allows for joint distributions.
What about the formula?
Each participating employee has a “hypothetical” account balance. In most instances, the account balance begins at zero in the first year. At that point, pay credits and interest credits are added to the hypothetical account balance.
Pay credits are typically stated as a percentage of pay. But they can also be a flat dollar amount. This “credit” is added to the account annually. But it’s important to note that the sum of hypothetical employee accounts will not equal the investment account balance.
Interest credits are also added to the account balance. The interest crediting rate is specified in the plan document. The interest crediting rate can be a fixed rate or variable. A variable rate is tied to an index, such as a Treasury bill, Treasury note rate, or the consumer price index.
If desired, the interest credit can be tied to the actual plan investment or market return. However, this can create more volatile results and contribution amounts.
|Benefits ✅||Downsides ❌|
|Qualified Asset Protection||Permanent Structure|
|Min/Target/Max Funding Range||Higher Plan Cost|
|Large, Tax Deductible Contributions||Required Actuary Review|
|Custom Tailored Design||Complex Administration|
What about investments?
Defined benefit plans are typically invested in the stock and bond market, like a 401(k) plan, and managed professionally by a sponsored investment firm. The investments are actively managed and are not chosen by each employee.
An actively managed account is an investment account regularly managed by an investment professional, based on the client’s (in this case, the employer) risk tolerance and funding goals.
But if the plan’s investment returns are less than the guaranteed rate, the employer will need to increase future contributions. This difference is generally spread out over several years. The plan sponsor and trustee have various investment options to achieve the interest credit rate illustration.
Once your plan is set up and you have a defined benefit plan illustration, you must use an investment platform. Here is some information regarding the custodians and advisors that we work with.
The selection of investments for participant-directed 401(k) plans requires that the officers or committee members answer the following questions:
- Is each investment option prudent and suitable for the participants?
- Do the funds, in total, constitute a diversity of investment options?
- Is the investment package suitable for the abilities of the particular workforce–or, if not, can it be made so through offering investment education or advice to the participants?
Fiduciaries must monitor the funds and remove any funds that don’t perform well. Some investment providers (such as insurance companies, mutual fund companies, and banks) help fiduciaries by giving them performance, expense, benchmarks, and other information and removing underperforming funds from their investment packages.
Other advisors, such as investment consultants, can help the fiduciaries evaluate the participants’ investments.
Final Thoughts on DB Plans
So what is a DB Plan? As you can see, DB plans are one of the best tax planning and retirement structuring tools in the market. No other plans allow self-employed people to make such substantial tax deferred contributions.
But you don’t have to take my word for it. Just submit a request below and we will run you a free illustration so you can see for yourself. You may have just uncovered an excellent retirement tool!