Defined Benefit Plans | SAVVY RETIREMENT

Defined Benefit Pension Plans

There are two general categories of retirement plans — defined benefit plans and defined contribution plans. In general, defined benefit plans provide a specific benefit at retirement for each eligible employee, while defined contribution plans specify the amount of contributions to be made by the employer toward an employee’s retirement account.

Pros

Substantial benefits can be provided and accrued within a short time – even with early retirement
Employers can contribute (and deduct) more than under other retirement plans
Plan provides a predictable benefit at retirement age
Vesting can follow a variety of schedules from immediate to spread out over six years
Benefits are not dependent on asset returns

Cons

Most expensive form of plan
Most administratively complex plan
In most all years, a contribution must be made
Employee benefits cannot be retroactively reduced

Defined benefit plans provide a fixed, pre-established benefit for employees at retirement. Employees often value the fixed benefit provided by this type of plan. On the employer side, businesses can generally contribute (and therefore deduct) more each year than in defined contribution plans. However, defined benefit plans are often more complex and, thus, more costly to establish and maintain than other types of plans.

If you establish a defined benefit plan, you:

Can have other retirement plans
Can be a business of any size
Need to annually file a Form 5500 with a Schedule SB
Need an Enrolled Actuary to determine the funding levels and sign the Schedule SB annually
Cannot retroactively decrease benefits
Must create a governing plan document

Who contributes

Generally, the employer makes most contributions. Sometimes, employee voluntary contributions may be permitted.

Contribution and benefit limits

Benefits provided under the plan are limited. Generally, the benefit limits are higher than those allowed in defined contribution lans. An Enrolled Actuary is needed to determine the contribution and benefit limits.

Filing requirements

Annual filing of Form 5500 is required. An Enrolled Actuary must sign the Schedule SB of Form 5500.

In-service withdrawals

Generally, a defined benefit plan may not make in-service distributions to a participant before age 62.

How do defined benefit plans work?

In a typical defined benefit plan, a participant’s benefit is expressed as a monthly benefit payable at retirement age for the rest of the participant's and, in some cases, their spouse's life. Increases and decreases in the value of the plan’s investments do not change these amounts. Thus, like the cash balance the investment risks are borne solely by the employer.

When a participant becomes entitled to receive benefits under a defined benefit plan, the benefits that are received are defined in terms of monthly benefit. For example, assume that a participant has been a participant in a defined benefit plan for five years and has an accrued benefit of $708 per month when he or she reaches age 65. If the participant decides to retire at that time, he or she would have the right to take that benefit as an annuity for at least the rest of their life. However, in many defined benefit plans, the participant could instead choose (with consent from his or her spouse) to take a lump sum benefit. This single sum would be approximately $100,000, depending on the interest rate in place at the time of the payment. If a participant receives a lump sum distribution, that distribution generally can be rolled over into an IRA or to another employer’s plan if that plan accepts rollovers.

The benefits in traditional defined benefit plans, are protected, within certain limitations, by federal insurance provided through the Pension Benefit Guaranty Corporation.

How do defined benefit plans differ from 401(k) plans?

There are four major differences between typical defined benefit plans and 401(k) plans:

Participation - Participation in typical defined benefit plans generally does not depend on the workers contributing part of their compensation to the plan; however, participation in a 401(k) plan does depend, in whole or in part, on an employee choosing to contribute to the plan.
Investment Risks - The investments of defined benefit plans are managed by the employer or an investment manager appointed by the employer. The employer bears the risks of the investments. Increases and decreases in the value of the plan’s investments do not directly affect the benefit amounts promised to participants. By contrast, 401(k) plans often permit participants to direct their own investments within certain categories. Under 401(k) plans, participants bear the risks and rewards of investment choices.
Life Annuities - Unlike 401(k) plans, defined benefit plans are required to offer employees the ability to receive their benefits in the form of lifetime annuities.
Federal Guarantee - The benefits provided by defined benefit plans are usually insured by a federal agency, the Pension Benefit Guaranty Corporation (PBGC). If a defined benefit plan is terminated with insufficient funds to pay all promised benefits, the PBGC has authority to assume trusteeship of the plan and to begin to pay pension benefits up to the limits set by law. Defined contribution plans, including 401(k) plans, are not insured by the PBGC.