A deferred pension plan (also called a defined benefit plan) is a specific type of retirement plan. In the right situation, these plans are home runs for high-income business owners.
In this post, we will discuss how these plans work and point out a few options. Hopefully, you can implement a plan that will work for your business. Let’s dive in!
Why should you consider a deferred pension plan?
A deferred pension plan is a structure where the employer guarantees employees a specific amount of retirement income based on a particular formula that considers factors such as salary and years of service. A defined benefit plan can be a good option for professional practice to consider for several reasons:
- Attracting and retaining employees: A defined benefit plan can provide a significant retirement benefit to employees, which can help the practice attract and retain top talent.
- Tax advantages: A defined benefit plan can provide tax advantages for employers and employees. Employer contributions to the plan are tax-deductible, and the money can grow tax-free until the employee withdraws it.
- Higher contribution limits: Defined benefit plans have higher contribution limits than defined contribution plans, such as 401(k)s. This means that the practice can make larger contributions to the plan on behalf of its employees.
- Favorable treatment of highly compensated employees: Defined benefit plans are subject to specific nondiscrimination tests, making it easier for highly compensated employees to participate in the plan and receive larger benefits than they would with a defined contribution plan.
- Professional management: Defined benefit plans are typically professionally managed, which can take the burden of investment decision-making off of the employees.
How do you structure a defined benefit plan?
Here’s how it works:
- Eligibility: Employees who meet the eligibility criteria set by the employer can participate in the defined benefit plan. Typically, eligibility is based on length of service, age, and job title.
- Contribution: The employer is responsible for funding the plan, and contributions are made to a trust fund set up for the exclusive benefit of plan participants. The employer may also require employees to contribute to the plan, but this is less common.
- Benefit Calculation: The benefit formula used to calculate the retirement benefit is based on factors such as the employee’s salary and years of service. The benefit amount is typically fixed per month, but some plans may offer a lump sum payment option.
- Vesting: Employees who become eligible to participate in the plan accrue benefits. Vesting refers to becoming entitled to the benefits earned under the plan. Typically, vesting occurs over the years, and once an employee is fully vested, they are entitled to the full benefit amount.
- Payout: Employees who retire begin receiving their retirement benefit from the plan. The benefit amount is usually a monthly annuity, but some plans may offer a lump sum payment option.
- Risk: The employer assumes the investment and longevity risks associated with the plan. Investment risk refers to the chance that the assets in the plan will not perform as expected, while longevity risk refers to the risk that plan participants will live longer than expected and the plan will run out of money.
Overall, a deferred pension plan provides employees with a guaranteed retirement benefit, which can provide peace of mind and financial security in retirement.
What type of company should consider a deferred pension plan?
A defined benefit plan could be a good fit for certain types of companies, including:
- Companies with stable, predictable cash flow: A defined benefit plan requires the employer to make regular contributions to the plan to fund the retirement benefits promised to employees. Therefore, companies with stable and predictable cash flows are better suited to this type of plan, as they can more easily budget for and make these contributions over time.
- Companies with a small number of employees: A defined benefit plan can be more expensive to administer than other types of retirement plans, such as a defined contribution plan. Therefore, companies with a relatively small number of employees may find that the cost of administering the plan is more manageable.
- Companies with a long-term outlook: A defined benefit plan is a long-term commitment. The company is responsible for funding the plan over many years to provide employees with retirement benefits. Therefore, companies with a long-term outlook and a commitment to providing stable retirement benefits to their employees may find that a defined benefit plan is a good fit.
- Companies desiring to attract and retain high-quality employees: A deferred pension plan can be a valuable tool for attracting and retaining high-quality employees, as it provides a guaranteed retirement benefit not subject to market fluctuations. This can particularly appeal to employees looking for stability and security in their retirement planning.
| Pros | Cons |
|---|---|
| Tax-Deferred Contributions | IRS Permanency Rules |
| Easy Plan Rollover | High Set Up Costs |
| Tailored Business Design | Mandatory Funding |
| Flexible Funding Range | No Employee Deferral Options |
In summary, a defined benefit plan may be a good fit for companies with stable cash flows, a relatively small number of employees, a long-term outlook, and a desire to attract and retain high-quality employees. However, it is essential to note that each company’s situation is unique, and it is vital to consider the costs and benefits of any retirement plan before deciding.
Deferred defined benefit pension advantages
A defined benefit plan is a retirement plan that promises a specific retirement benefit to employees based on a formula that typically considers the employee’s salary history, years of service, and age. Some advantages of a defined benefit plan include the following:
- Predictable retirement income: Employees can have a more predictable retirement income stream with a defined benefit plan since the plan specifies the amount of retirement income they will receive.
- Employer-funded: The employer funds the plan and ensures sufficient assets to pay promised benefits. Employees do not have to worry about market fluctuations or investment risks affecting their retirement income.
- No investment decisions: Employees do not have to make investment decisions, which can be complicated and time-consuming. The employer manages the investments and bears the investment risk.
- Lifetime benefits: Defined benefit plans generally provide lifetime benefits, which means that employees do not have to worry about outliving their retirement savings.
- High contribution limits: Defined benefit plans generally have higher contribution limits than defined contribution plans, such as 401(k)s. This can be advantageous for employees who want to save more for retirement.
- Tax advantages: Defined benefit plans offer tax advantages for both employers and employees. Employers can deduct contributions on their taxes, and employees can defer taxes on their contributions and any investment gains until they withdraw the benefits in retirement.
A defined benefit plan can provide employees with a secure and predictable retirement income stream without the investment risks and responsibilities associated with defined contribution plans.
Final thoughts
While cash balance plan administration fees can be higher than other retirement plans, they may be offset by the potential tax benefits and retirement savings opportunities for both the employer and the employees participating in the plan. It is important for employers to carefully consider the costs and benefits of establishing and maintaining a cash balance plan and work with their plan administrator to understand and manage the plan’s administrative fees.
Employers should also compare costs across different plan administrators to ensure they receive competitive pricing for the required services. Some plan administrators may offer bundled pricing packages that include all necessary administrative services, while others may charge separately for each service. It is essential to carefully review and compare pricing and service offerings to decide on selecting a plan administrator.
