Defined Benefit Plan Vs 401k: Which is best?

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When most people examine a pension vs 401k, they are comparing a defined benefit plan to a defined contribution plan. In fact, the Internal Revenue Code (IRC) has defined pension plans as either defined benefit or defined contribution.

So in reality we should be comparing a defined benefit plan to a defined contribution plan, not a pension vs 401k. This is where there are substantial differences.

In a defined benefit plan, the benefit is stated as an annual payment that starts at the participant’s normal retirement age that is specified in the plan. The benefit is calculated with the help of an actuary using a formula that typically includes a participant’s years of employment, annual earnings, or a combination of the two. The employer will fund the plan to a level sufficient to pay the benefit at the future date.

According to the Bureau of Labor Statistics, most pension participants in medium to large companies with defined benefit plans use a formula commonly known as “final average pay.” This formula utilizes earnings in the participant’s most recent years to calculate the benefit amount.

Typically, the retirement benefit is a calculated as a percentage of the employee’s final years of compensation multiplied by the  length of service. Accordingly, higher final compensation and longer length of service means a great retirement benefit.

Which is better?

Since we are no longer looking at Pension vs 401k, but defined benefit plan to a defined contribution plan, lets determine which is better. 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.

Financial planning puzzle piece

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.

Tell me about the defined benefit plan

A defined benefit plan is a retirement plan in which the employer, not the employee, pays all of the benefits. This plan can be structured so that the employee receives benefits as lump sum payments or fixed monthly payments over a defined period of time.

The employer also bears the responsibility of investing and managing the plan’s 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.

The rules of the plan are complex. For example, a defined benefit plan cannot provide benefits for certain employees. However, it must provide a minimum benefit and accelerate vesting. The plan must also attribute benefits to key employees at a minimum rate of 60%.

Employees can be the spouses, children, parents, and siblings of key employees. In addition, a defined benefit plan cannot give benefits to individuals who have never worked for the employer.

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.

What about the 401k?

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 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.

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 twenty one. 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 401k

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 Pension vs 401k.. 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 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 participants 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.

Paul Sundin

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