Disadvantages of Defined Benefit Plans [+ IRS Pitfalls❌]

Defined benefit plans are my favorite retirement structure for high-income business owners. But are you aware of the disadvantages of defined benefit plans?

There are several situations where these plans do not work well!

First, we’ll provide a summary and then dive into the details. After the table of contents, we have a video that addresses many of the disadvantages. Let’s dive in!

Top Defined Benefit Plan Disadvantages:

• Annual administration can be costly ($2k to $3k). But there are many benefits for a high-income business owner.
• Excise tax may be assessed if minimum funding is not met. But the actuary can assess the risk for you.
• The plans are permanent and not elective. You are not required to have them forever, but you should have them for at least a few years.
• Generally, you are required to make mandatory contributions.

In this post, we will walk through many of the disadvantages of the plans. For the right person though, they can be the best retirement structure.

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What is a defined benefit plan?

A defined benefit pension plan is a specific retirement structure in which an employer promises to pay a specified benefit amount to an employee upon their retirement. This benefit amount is typically based on a formula considering the employee’s years of service, age, and salary history. The employer is responsible for funding the plan; the benefit amount is guaranteed, regardless of how the plan’s investments perform.

Defined benefit plans are different from defined contribution plans, such as 401(k) plans, in which the employer and employee contribute to an individual account that is invested, and the ultimate benefit amount depends on the performance of those investments.

Defined benefit plans were once a standard retirement plan offered by employers, but they have become less popular in recent years due to their cost and complexity. However, some employers still offer them, particularly in the public sector.

Why would you want to set up a defined benefit plan?

There are a few potential reasons why an employer might want to set up a defined benefit plan:

1. Attract and retain employees: A defined benefit plan can be a valuable employee benefit that can help attract and retain top talent.
2. Predictable retirement income: A defined benefit plan provides employees with a predictable level of retirement income, which can be reassuring for employees who are planning for their retirement.
3. Tax benefits: Contributions to a defined benefit plan may be tax-deductible for the employer and tax-deferred for the employee. This can provide some tax benefits for both parties.
4. Potential for higher benefits: Because defined benefit plans are funded by the employer, they have the potential to provide higher benefits than defined contribution plans, such as 401(k)s, which are funded by employee contributions.

A defined benefit plan may not be the best choice for every employer, as there are also potential disadvantages to consider. Employers should carefully weigh the pros and cons of a defined benefit plan before deciding whether it is the right choice.

What are the disadvantages of a defined benefit plan?

The plan disadvantages include higher fees, conservative investment growth, permanency rules and mandatory contributions. Employees may choose between a lump-sum payment or an annuity stream upon retirement. These plans can have significant risks for both employees and employers.

A defined benefit plan is a type of retirement plan in which an employer promises to pay a certain amount of money to an employee upon retirement. Below we will discuss some of the potential disadvantages of defined benefit plan.

Complexity

There is no doubt that defined benefit plans are the most complex plans for both employees and employers to understand. Actuaries are the ones that will determine funding levels and often business owners are in the dark.

Since the employers are required to make all the contributions, changes in employee mix and investment returns, can lead to volatility. This volatility can sometimes raise cash flow concerns, which can make it challenging for a company to fund the plan. Employers are locked into funding the plan until a plan is frozen or terminated.

Defined benefit plans can be complex to administer, especially for small businesses. There are many rules and regulations that must be followed in order to maintain the plan.

Funding risk

Defined benefit plans are funded by the employer, and the employer is responsible for making sure there is enough money in the plan to pay out the promised benefits. If the employer’s financial situation changes, the plan may not be fully funded, which could put the promised benefits at risk.

Limited flexibility

Defined benefit plans typically do not offer employees the same level of flexibility as defined contribution plans, such as 401(k)s. For example, employees may not be able to choose how their benefits are invested or how much they contribute to the plan.

In some cases, defined benefit plans may be underfunded, or the employer may face financial difficulties that make it difficult to fully fund the plan. In these situations, the employer may be required to cut back on the promised benefits in order to keep the plan solvent.

Defined benefit plans are typically tied to an employee’s job, and the benefits are not portable if the employee changes jobs. This can be a disadvantage for employees who switch jobs frequently or who are self-employed.

Tell me about the set-up process

To set up a defined benefit plan, an employer will need to follow these steps:

1. Choose a plan sponsor: The plan sponsor is the entity responsible for overseeing the plan and ensuring that it is administered in accordance with the law. This could be the employer itself or a third party, such as a financial institution or insurance company.
2. Select a plan administrator: The plan administrator is responsible for managing the day-to-day operations of the plan, including enrolling employees, calculating benefits, and paying out benefits when employees retire.
3. Determine the plan’s benefits: The employer will need to decide how much money will be paid out to employees upon retirement, as well as any other benefits that will be provided under the plan.
4. Establish a trust: A trust is a legal entity that holds the assets of the plan and is responsible for investing them and paying out benefits to plan participants. The employer will need to set up a trust and transfer assets to it in order to fund the plan.
5. Create a plan document: The plan document is a written document that outlines the terms and conditions of the plan. It will need to be drafted and signed by the employer and the plan sponsor.
6. Obtain any necessary approvals: Depending on the jurisdiction in which the plan is being set up, the employer may need to obtain approval from regulatory agencies or other authorities before the plan can be implemented.

It’s important to note that setting up a defined benefit plan can be a complex process, and it may be advisable to seek the assistance of a legal or financial professional to ensure that all necessary steps are taken correctly.

Why a business owner should consider a defined benefit plan

There are several reasons why a business owner might consider offering a defined benefit plan to their employees:

However, it is important to note that defined benefit plans can be complex and expensive to administer and may not be suitable for every business. It is advisable for a business owner to carefully consider the costs and benefits of a defined benefit plan before deciding to offer one to their employees.

Final thoughts

A defined benefit plan is a type of retirement plan in which an employer promises to pay a certain amount of money to an employee upon retirement. The amount of the benefit is typically based on factors such as the employee’s salary and length of service.

To fund a defined benefit plan, the employer makes contributions to the plan on behalf of its employees. These contributions are generally tax-deductible for the business and are invested to grow over time. The investment income earned by the plan is tax-free until it is paid out to employees upon retirement.

However, it is important to note that defined benefit plans can be complex and expensive to administer. As such, they may not be suitable for every business. Employers who offer defined benefit plans are responsible for ensuring that the plan is properly funded and that the benefits promised to employees are paid out as promised. This can require careful planning and ongoing management of the plan’s assets.

Overall, a defined benefit plan can be a valuable benefit for employees and a useful tool for attracting and retaining top talent. However, it is important for businesses to carefully consider the costs and benefits of offering such a plan before making a decision.