Defined benefit pension plans are probably the #1 retirement structure. They work great for business owners in the right situation. But you may be looking for examples of defined benefit plans?
In this post, we will discuss how these plans work and discuss the various types of defined benefit plans. We will even show you some illustrations and give you some client examples.
These plans aren’t for everyone. But in the right situation they can be a home run for the business owner. Let’s get started!
What is a defined benefit plan?
A defined benefit pension plan is a type of retirement structure. The company promises to pay a certain amount of money to an employee upon retirement. The amount of the benefit is normally based on factors such as the employee’s salary, age and length of service. It is often expressed as a formula, such as a certain number of dollars per year of service.
For example, a defined benefit plan might provide an employee with a benefit of $50 per year of service. For example, an employee who has worked for the company for 20 years would receive a benefit of $1,000 per month upon retirement.
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.
Upon retirement, employees receive their defined benefit in the form of a regular payment, typically on a monthly basis. The payment may be for a fixed period, such as a certain number of years, or for the employee’s lifetime.
One of the key advantages of a defined benefit plan is that it provides a predictable and stable source of income for employees. This can be particularly valuable for employees who are planning for their financial future. They want to know exactly how much money they will have when they retire.
There are several different types of defined benefit plans, including traditional pension plans, cash balance plans, and hybrid plans. Traditional pension plans are the most common type of defined benefit plan and provide a fixed benefit based on the employee’s salary and years of service. Cash balance plans combine elements of traditional pension plans with those of defined contribution plans, such as 401(k) plans.
Examples of Defined Benefit Plans
Some common examples of defined benefit plans include:
|Traditional Defined Benefit Plan
|Pension plans provide a guaranteed level of income to employees upon retirement, typically based on factors such as the employee’s salary and length of service.
|Cash Balance Plan
|Probably the most popular plan type. It is a type of hybrid plan that presents itself more like a 401k plan thanks to the participant account statements.
|Benefit equalization plan
|These are plans that are designed to equalize the benefits of employees who have different lengths of service or who are paid at different rates.
Hybrid plans: These are plans that combine elements of defined benefit plans with elements of defined contribution plans, such as 401(k) plans. Hybrid plans may provide a guaranteed benefit to employees upon retirement.
Defined benefit plans can be complex and may have specific rules and requirements that must be followed. 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.
Examples of traditional defined benefit plans are flat benefit, unit benefit, floor-offset, cash balance and fully insured IRC §412(e)(3)
plans. Defined benefit plans can provide benefits other than retirement benefits (for example death or disability benefits) based on objective criteria.
The traditional qualified defined benefit plan provides a stated monthly benefit at retirement for as long as the participant lives. Also, defined benefit plans must, by law, provide benefits to a participant’s spouse and may provide benefits to other beneficiaries as well.
In a defined benefit plan, the employer guarantees the benefit that the participant is to receive. The employer bears the investment risk since the employer is required to make sufficient contributions to pay the benefits under the plan and must increase contributions to make up for any unexpected investment losses.
The term “pension” can mean two different things. Many people use the word “pension” to refer to retirement plans in general. In other cases, particularly in the IRC and regulations, “pension” refers to a specific type of retirement plan, such as a defined benefit pension plan.
In the latter case, some defined contribution plans are considered to be pension plans. For example, target benefit plans and money purchase plans are defined contribution plans that are also considered pension plans. Profit sharing plans, including 401(k) plans, are not considered to be pension plans because they do not require certain contribution levels on an annual basis.
IRC §401(a)(26) requires a minimum number of plan participants. A plan must benefit the lesser of (1) 40% of all employees with a
minimum of two, or (2) 50 employees. Plans cannot be aggregated to meet this requirement.
As the name suggests, defined benefit plans generally provide participants with a benefit amount that is defined in the plan document. Defined contribution plans, conversely, provide participants with a contribution amount that is defined in the plan document.
Why should a business owner consider a defined benefit plan
There are several reasons why a business owner might consider a defined benefit plan:
- Attract and retain top talent: Defined benefit plans can be a powerful tool for attracting and retaining top talent. They provide a guaranteed retirement benefit that can help to provide financial security in the employee’s retirement years. This can be particularly attractive to employees who are considering multiple job offers.
- Tax benefits: Employer contributions to a defined benefit plan are generally tax-deferred. This means they are not taxed until they are withdrawn from the plan at retirement. In addition, the investment earnings on the plan’s assets are tax-deferred. This can help to reduce the overall cost of the plan for the business owner.
- Predictability: Defined benefit plans offer a predictable, long-term retirement plan for both the employer and employees. The employer’s contributions to the plan are based on a predetermined formula, which helps to ensure that the plan is financially stable and able to meet its obligations to employees.
- Employee loyalty: Defined benefit plans can foster a sense of loyalty among employees. They are generally more committed to the company if they know that they will receive a guaranteed retirement benefit upon reaching retirement age. This can help to reduce employee turnover and improve the overall performance of the company.
Overall, a defined benefit plan can be a powerful tool for a business owner to attract and retain top talent. It also provides tax benefits and predictability for the business. It is important for business owners to carefully review the features and requirements of a defined benefit plan and to consult with a qualified professional.
Examples and Characteristics of Defined Contribution Plans
A defined contribution plan maintains an account balance for each participant so that the entire benefit is derived from each participant’s account. Upon retirement or termination of employment, the participant is entitled to the money in their account balance. Contributions are made to the plan each year and allocated in some nondiscriminatory manner specified in the plan document.
Depending on the type of plan, contributions may or may not be required. Most often, the contribution is discretionary. Examples of defined contribution plans are profit sharing, money purchase, stock bonus, employee stock ownership, target benefit, 401(k), 403(b), and 457 plans.
Most profit-sharing plans do not have a required contribution. However, once a contribution has been made, it is allocated to the participant accounts under the plan document.
Contributions for participants to a target benefit plan are calculated at each person’s age. The contribution, when accumulated to retirement, will provide a uniform target benefit. These contributions are allocated to the participant’s account. The benefit paid at retirement is based upon the participant’s account balance, which (depending on actual earnings) may be greater or less than the target benefit.
In a defined contribution plan, depending on the plan’s terms, plan assets may be commingled in an investment pool (so that each participant’s account is a bookkeeping entry), or each account may be separately invested. The investment of commingled accounts can be trustee or participant-directed.
The ultimate benefit the participant receives from a defined contribution plan is based entirely on the participant’s account balance. For this reason, the participant bears the risk of investment since low investment returns will result in a smaller benefit at retirement. The employer does not guarantee the benefits under a defined contribution plan. A defined contribution plan generally favors younger employees since money invested over a long period tends to accumulate to large amounts.
Defined contribution plans are subject to vesting requirements. A defined contribution plan must have a vesting schedule as least as generous as one of the following:
• 3-year cliff – participants are 100% vested upon being credited with three years of
• 6-year graded – participants vest 20% per year beginning with being credited
with two years of service, becoming 100% vested with six years of service.
Author: Paul Sundin, CPA
Paul is the founder and CEO of Emparion. He has worked with thousands of companies on tax planning and retirement structuring, including Inc 5000 companies, global brands and Silicon Valley startups. You can find out more about him here.