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Retirement Plan Types: Defined Benefit

Defined Benefit Plan Overview

Employers who do not require absolute discretion when determining the amount of their annual retirement plan contribution often establish Defined Benefit Plans. Typically, this is an employer whose annual profit picture does not fluctuate and therefore can commit to an annual required contribution. The contributions are then invested in the plan's trust account and used to pay benefits to participants at retirement, death, disability, or termination of employment.
The Defined Benefit plan is designed to pay a fixed benefit upon retirement. The benefit is based on the formula outlined in the plan document. The contributions are actuarially determined on the anticipated benefit at retirement. The factors that determine the total contribution are: Participants’ compensation; trust account earnings; participants’ ages; and years of service.
The plan sponsor bears investment risk because plan benefits don’t depend on contributions or investment results. If the assets fail to earn the rate of return used as the actuarial assumption, a greater contribution may be required the following year. Or, conversely, if the investments outperform expectations, the plan will have an actuarial gain, which may reduce future contribution requirements.

Advantages of Defined Benefit Plans:

  • In many cases, allows for a greater tax-deductible contribution than other plan types.
  • Provides higher benefits to older owners and/or key employees
  • Provides a more significant benefit to older employees who are approaching retirement.
  • Rewards employees who remain employed for many years.

Additional information pertinent to Defined Benefit Plans:

  • Contributions are required to pay benefits determined by a formula set forth in the plan document.
  • The annual compensation limit is $270,000 for plan years beginning in 2017.
  • Participants are able to calculate what their future retirement benefit will be, though the mathematics can be complex.
  • The annual benefit that may be paid to a participant is generally limited to the lesser of $215,000 in 2017 or 100% of the participant’s average compensation for the highest three consecutive years.
  • The Internal Revenue Code requires that the employer meet annual minimum funding requirements.
  • Depending upon the nature of the business sponsoring the plan, insurance premiums payable to the Pension Benefit Guaranty Corporation (PBGC) may be required.
  • Please see our special addendum below for additional information regarding cash balance/defined benefit pension plans.

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Cash Balance Plan Overview

The Cash Balance Plan had its genesis as an innovative retirement plan designed and created by Bank of America. The Bank wanted a pension plan, but with a simulated account balance that would appeal to its workforce. Like a pension plan, the plan's assets would grow by two (2) means: 1). a company contribution, or pay credit, and 2). investment earnings ("Interest Crediting Rate/ICR").

This pay credit was typically a set, single digit percentage of the eligible workers' annual pay, but it could be varied on a periodic basis with proper advance planning; while the interest credit concept gives the employer much more flexibility in setting this annual interest rate, with both a "0 -  floor", and "market rate of return - ceiling".

Furthermore, under the September 2014 final regulations, the employer can tailor its interest crediting rate (ICR) for different cohorts of employees; much like a 401(k) participant would choose a target date fund as an investment vehicle.

The Cash Balance plan provides the following advantages:

     1). Both the Employer and the Employee appreciate the ability to make much higher annual Employer contributions on behalf of the Employer's key professionals with an immediate income tax deduction, but the costs to the Employer are much less volatile, with more predictable annual pension cost.

     2). The Employer appreciates that funding can be "Age Neutral" such that a flexible contribution amount can be made for business partners/co-owners of varying chronological ages.

     3). The Employees understand, and thus appreciate, having a pension benefit denominated in an account balance similar to the simpler profit sharing plan.

     4). As a result of this original design and the follow-on regulatory pronouncements, cash balance plans are becoming much more popular than traditional defined benefit pension plans, and are growing rapidly in sheer number of plans, aggregate number of plan participants, and overall dollar assets under management.

Of course, some unique rules apply to Cash Balance plans such as the required 3 year vesting schedule, but the surge in the implementation of Cash Balance Plans clearly show that this concept is an attractive option for those small and middle market Employers who have a stable and profitable cash flow, and a desire to maximize the accumulation of retirement funds for key employees.

 

 

 

 

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