Defined Benefit Plans: Rules, Pros and Cons + FAQs

Defined benefit plans offer large, tax-deferred contributions plus guaranteed benefits. What’s not to like? It seems that they are superior plans compared to other retirement structures.

But that’s not always the case.

If not used correctly, defined benefit plans can offer many pitfalls. But if used correctly, they are a powerful game-changer in your retirement arsenal. Here’s how these plans can work for you.

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Understanding retirement plan differences

Defined benefit plans and 401(k)s are both retirement savings options that have been created to help employees save for their future. However, these plans are very different and have features that make them unique.

The terms “retirement plan” or “pension” are used loosely. In fact, many people believe they’re the same thing even though there are some significant differences.

When it comes to retirement plans, there really are two broad categories: defined benefit plans and defined contribution plans. These two different plan types are essential to understand. The most popular type of retirement plan is a 401(k) plan. This falls under the defined contribution plan category.

So the first step of the process is defining the difference between defined benefit plans and defined contribution plans. This can get challenging, so try to hang in there.

A defined contribution plan has an established IRS limit for each tax year. Once a participant contributes up to the allowable amount, a tax deduction is taken, and the employee can invest the funds as they see fit.

From a compliance standpoint, once the money is in the account, it does not matter if it goes up or down. That’s because the allowable contribution was determined in the given year, and changes in the investment account from year to year do not impact plan compliance.

But a defined benefit plan works a little differently. These plans define a benefit pension amount at some point in the future. Let’s say, for example, the employee is supposed to have $1 million in an account at age 62.

Since the defined benefit amount is at a date in the future (and assuming the employee qualifies for that amount), the employer will make annual contributions to reach that goal amount at a future date.

Is a defined benefit pension better than a 401(k)?

As you can tell, defined contribution plans are much easier to administer because compliance is only based on the initial contribution. However, defined benefit plans require ongoing compliance and administration because the actuary must monitor the employer contributions and investment balances so that the employee has the proper balance at retirement and to ensure the company funds the plan accordingly.

Another key difference is that defined contribution plans typically represent employee contributions. A 401(k) plan generally has two types of contributions: employee deferrals and employer profit-sharing. On the other hand, a defined contribution plan is a retirement structure in which the employer and/or the employee contribute to an individual account for the employee. Employees typically have more control over their retirement savings and investment decisions in a defined contribution plan.

However, with a defined benefit pension plan, the employer makes all contributions, and employees are not allowed to make deferrals. The retirement income the employee will receive is based on the employer the benefit the employee accrues. The employer bears the investment risk, and the employee is not responsible for providing a specific retirement benefit amount.

Define benefit plans are certainly more costly to administer. The plans require that a plan actuary signs off and certifies compliance to the IRS annually. This certification substantially increases plan costs and compliance tasks.

In a defined benefit plan, the company assumes more responsibility for managing the investments and ensuring that promised benefits are paid. Defined contribution plans, such as 401(k) plans, are more commonly offered by employers today, while defined benefit plans are less common.

A 401(k) plan allows employees and employers to contribute to a tax-deferred retirement account. However, a defined benefit plan promises employees a specified benefit at retirement and places the risk of providing the benefit on the employer. The plan could state the retirement benefit as a specified dollar amount, such as $2,000 a month.

Is a 401(k) Plan a Defined Benefit Plan?

No, it is not. A 401(k) plan is actually a defined contribution plan. Participants may elect to defer a portion of their wage that is then contributed to the plan. In many situations, the employer will match a portion of these contributions.

The good news is that you can combine these plans together and make substantial retirement contributions. But a 401(k) is a great starter plan, while a defined benefit plan is for a larger business or high-income self-employed person.

Defined benefit plan specifics

A defined benefit plan is a retirement structure in which the employer guarantees the employee a specific retirement benefit amount, usually based on a formula that considers the employee’s salary and years of service. The company is responsible for funding the plan and managing the investments to ensure sufficient funds to pay the promised benefits. The retirement income an employee will receive is predetermined, and the employer is responsible for ensuring that the promised amount is paid out.

A defined benefit plan is a type of retirement plan in which an employer promises to pay an employee a specific, predetermined benefit upon their retirement based on length of service and salary history.

In a defined benefit plan, the employer bears the investment risk and is responsible for contributing to the plan to ensure that the promised benefits are fully funded. The employer may invest the plan assets in various ways, such as in stocks, bonds, or real estate, to generate sufficient returns to pay for the promised benefits.

The benefits in a defined benefit plan are usually based on a formula considering the employee’s years of service and compensation. The plan typically provides for a lifetime annuity payment to the retiree.

Defined benefit plans have generally become less common in the U.S. for large employers. However, the plans have become more popular for small businesses looking for large contribution.

The employer also bears the responsibility of investing and managing the pension plan funds. In addition, the plan allows employers to allow voluntary contributions. The employer must follow certain rules regarding how the voluntary contributions will be invested.

Upon retirement, the employee will receive a specific amount of money based on the compensation they have earned throughout their employment. This amount may be a fixed amount, based on a formula, or a combination of both.

This benefit is funded by the employer and sometimes employees contribute as well. The employee’s contributions, in essence, constitute deferred compensation. This means that the employee is not paying any taxes until they reach retirement age.

401(k) plan specifics

A 401(k) plan is a retirement savings plan that allows employee/participants to contribute a portion of their pre-tax income into an investment account. The contributions and any earnings on the investments grow tax-deferred until withdrawn at retirement. Employers may also contribute to the plan by matching employee contributions up to a specified percentage or making non-elective contributions on behalf of employees.

401(k) plans are named after the US tax code section governing them. Employers in the United States commonly offer them as a benefit to their employees, and participation in the plan is usually voluntary. Employees may choose how much of their salary to contribute, up to certain limits set by the IRS.

401(k) plans offer several benefits, including tax-deferred growth, potential employer contributions, and automated retirement savings through payroll deductions. However, there are also a few potential downsides, such as limited investment options, fees, and penalties for early withdrawals.

In the first place, you must understand your 401k plan. A summary of your plan outlines its specific features and describes its eligibility rules, enrollment features, and distribution provisions. It’s critical to follow the rules in this document to maintain compliance with the Employee Retirement Income Security Act (ERISA).

Moreover, your plan should provide a Summary Plan Description to your beneficiaries. If you do not do this, the plan administrator may be violating federal law.

The sponsor must also meet certain standards to maintain compliance with nondiscrimination regulations. These pension regulations include not excluding employees solely based on age, or limiting the plan to employees of a certain age or sex.

Additionally, you must follow certain procedures, including a non-discrimination test. Some companies even choose to make this election for their 401k plans. Whether you make a lot or little depends on your situation.

Defined benefit plan pros and cons

A defined benefit plan, also often known as a traditional pension plan, is a retirement savings plan that an employer sponsors. This plan provides a guaranteed income to the employee after they retire. The employer is responsible for contributing to the plan, and the employee’s retirement benefits are based on a formula that considers their years of service and salary history.

Pros:

1. Guaranteed Income: DBPs provide the employee a guaranteed income after retiring. This means the employee can rely on a steady income stream even if their investment returns are poor.
2. Employer Contributions: In a DBP, the employer is responsible for contributing to the plan, so the employee does not have to worry about funding the plan themselves.
3. Predictable Benefit: The Benefit received from a DBP is predictable, based on a formula that considers the employee’s years of service and salary history.

Cons:

1. Limited Portability: DBPs are not portable, which means that if the employee changes jobs, they will not be able to take their benefits with them.
2. Limited Investment Options: DBPs typically offer limited investment options, so the employee may need help choosing the investments they want.
3. Dependent on Employer: The employee’s benefits depend on the employer, so if the employer goes bankrupt or discontinues the plan, the employee may lose their benefits.

401(k) plan pros and cons

A 401k Plan is a type of retirement savings plan that an employer sponsors. The employee contributes to the plan, and the employer may also contribute. The money in the plan grows tax-free until it is withdrawn, and the employee is responsible for making investment decisions.

Pros:

1. Portability: 401(k) plans are portable, meaning that employees can take their benefits with them if they change jobs.
2. Investment Options: 401(k) plans offer a wide range of options so the employee can choose suitable investments.
3. Employer Contributions: Some employers contribute to their employees’ 401(k) plans, which can help the employee save more for their future.

Cons:

1. No Guaranteed Income: 401(k) plans do not provide a guaranteed income, so the employee may have to rely on their investment returns to support themselves in retirement.
2. Self-Funded: The employee is responsible for funding their 401(k) plan, so they may have to save more to ensure that they have enough money for their future.
3. Market Risk: The employee’s investments in a 401(k) plan are subject to market risk, so their savings can be impacted if the market performs poorly.

Is a defined benefit plan better than a 401(k)?

First, defined contribution plans are calculated differently. Rather than looking at a final payout, the retirement benefit is the account balance of the individual employee. This account balance results from employee contributions and any matching contributions from the employer, plus any investment returns in the account.

In a defined contribution plan, the final benefits are not guaranteed, and participants bear the ultimate risk of loss as a result of poor investment performance. The most common (and best known) defined contribution plans is the 401(k) plan, which is named for the code section that provides for the plan’s tax preferences.

The 401(k) plan allows an employee to allocate a specific percentage of pay be set aside in the account and often an employer will match a certain portion of the employee’s contribution. The employee will then invest these amounts based on investment options specified in the plan document. The sum of the principal contributed (both employee and employer), investment returns (earnings or even losses) less any administrative or custodial expenses results in the ending account balance.

Pension participation requirements

You may be required to meet certain age and service requirements to participate in a 401(k) plan. Typically, the minimum age to join a plan is 21. For an employer to offer a 401(k) plan to employees, they must make at least one year of service.

The minimum amount of service must be at least one thousand hours. If you have a small business, you will need to offer a 401(k) plan to every employee.

Your 401k plan is governed by ERISA rules. These rules and regulations dictate the types of investments available to participants. An investment policy explains how you can invest your participants’ money. Your investment committee can use this information to identify investments that are underperforming and provide better returns.

It is important to note that many plan sponsors mistakenly believe that administering a 401(k) plan is free. The reality is, however, that all 401(k) plans cost money to maintain. In fact, most of these fees are hidden in the investments returned by plan participants.

Defined benefit plan vs 401(k)

But both defined benefit and defined contribution plans have evolved over the years. This has resulted in what we would call “hybrid” plans that have combined the characteristics of both plans, straying away from defined benefit plan vs 401(k). The most popular of these hybrid plans is the cash balance plan.

The cash balance plan is technically a defined benefit plan under the law even though it contains features that are similar to a defined contribution plan. Cash balance plans are not specifically called out in the law, but IRS has provided pension guidance for their funding and administration.

Cash balance plans define the employee benefit by reference to an employee’s hypothetical account balance. The cash balance plan then uses a formula, like defined benefit formulas, to specify the pension benefit to be paid at a future retirement date.

The cash balance plan is similar to a defined contribution plan in that the specified formula uses the pension benefits as a lump sum amount rather than as a series of monthly payments. The lump sum amount is determined based on using periodic pay along with an interest credit to the participant’s account. Pay credits would be based on a percentage of salary (like 6%) and interest credits are often a fixed amount (like 5%) or can be tied to the yield on a specific Treasury security.

How to determine which plan is best for your business

By considering these factors, a business can determine which type of plan would be best suited for its needs and the needs of its employees. It may also be helpful to consult with a financial advisor or pension plan specialist to evaluate the options and make a decision.

Final thoughts

Preparing for retirement is imperative. Most importantly, being a self-employed worker offers you an array of options to choose from.  

If you’re looking to set up a retirement plan, you have plenty of options. Your decision will likely come down to the number of employees, your available retirement funds, and your ultimate retirement goals. This post examined defined benefit plans vs 401(k)s and also examined some pension options.

A 401k Plan may best meet the needs of an individual who prefers to contribute around $60,000 per year. For individuals interested in contributing higher amounts or above 20-25% of income, a defined benefit plan could be the best avenue for a higher deduction and faster approach to reaching your retirement funding goal.