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A Defined Benefit Plan provides a specific pension or stream of payments when you retire. In other words it's a monthly paycheck you can not out live. Although the plan is based on you receiving a stream of payments for life, which we call a pension or annuity, you can also convert the pension to cash. It is usually best to take the pension and spread out the taxes due; you will only be taxed on the amount you receive. If you are married, the regulations set forth by the government suggest you take the annuity as a joint and survivor annuity. This means when you die your spouse will continue to receive benefits for as long as he or she lives. There are many possible pay out variations. Determining how you will receive the money does not have to be determined until you retire, terminate employment or stop the plan.
To obtain a stream of payments, it is best to transfer the money in the plan to an insurance company. Insurance companies can guarantee the payments and you don't have to rely upon yourself to prudently invest the money. The plan can also make payments according to a schedule based on interest and mortality. This requires the Trustees (generally the business owner) to properly manage the assets to guarantee that the plan doesn't run out of money. Most Trustees hire an investment manager to assist them in investing the money. Only insurance companies are approved to offer a lifetime benefit on a guaranteed basis.
Summary
A defined benefit plan provides a pension at some point in the future. All other types of plans are based on how much money is saved and how much it earns. So, the Defined Benefit Plan is guaranteed. Naturally, the Employer must maintain the plan for the employee to get the full benefit. If the plan is terminated the employees will get whatever they have accrued. I will expand on this issue later. The target is generally retirement age as defined by the plan. It's usually age 65 but it could be any age that is appropriate for your situation.
How large is the benefit at retirement?
The maximum pension depends on your age, length of time until retirement and your compensation history. The maximum as of this writing is a pension of $160,000 a year at age 65. This means at age 65 you will have accumulated enough money to pay out $160,000 a year for your entire lifetime.
What amount do I have to save to get to this goal?
The amount of savings, or contributions as we refer to them, depends on your age. The younger you are and the longer to retirement age the lower the contribution.
Example 1: If you are 56 years old, you will have to contribute $140,000 per year for ten years to reach the goal of $160,000 per year for life.
Example 2: If you are 62 and want to retire at age 66 (in five years instead of ten) the contribution becomes $170,000 per year and the pension would be $86,000 per year for life.
The contribution is determined based on how much money it takes at a given age to provide a stream of payments for your lifetime. It works something like a mortgage only in reverse. An annuity or a pension is a synonym for a stream of payments.
Let's look at the math
If it takes 1.8 million to provide a pension of $160,000 a year, how much do you have to save to reach the goal?
First, the government requires the actuary to assume a rate of interest that represents what the plan expects to earn. Generally, the accepted interest assumption ranges between 4% and 8%. The retirement goal of $160,000 has a future cash value determined by a government interest and mortality table. We will assume the goal to be $1,800,000. Therefore the future value is 1.8 million, the interest assumption is 5%, and the duration is your years to retirement. (Let's use 10 years).
If you think about this as a mortgage in reverse, you have a house worth 1.8 million that has to be paid off in ten years at 5% interest. What are your payments? Answer $140,000 per year.
In future years the contribution may increase or decrease depending upon how much above or below the interest assumption you achieve on your investments. Contributions may also increase or decrease, depending upon changes in employee salaries. Defined Benefit plans are usually tied to salary.
It is important not to confuse the pension with the contribution. The pension is the goal and the contribution plus expenses is the cost to get you there.
How is the money invested?
The government requires these plans to be certified by a licensed individual called an actuary, unless you buy the plan through an insurance company under the term "fully insured defined benefit plan" commonly known as a 412(i) plan. Instead of investing the money in stocks, bonds, real estate or any other prudent investment, all the money is invested in cash value insurance and/or annuities. The assumed earnings rate is the insurance company's guaranteed rate, usually 4%. You decide when you start the plan if you want to be responsible for investing the money or let the insurance company do it.
The first thing that may come to mind is that over time you may be able to do better than a 4% return on your money. If you make more than what the government requires the actuary to use as an interest assumption, generally 4% on 412(I) plans and 5% to 7% on traditional defined benefit plans, the additional earnings will reduce the contributions in the future. Conversely, if you don't earn the stated interest rate your company has to make up the difference. Trustees generally invest pension money very prudently, commonly in bonds and cash. Stocks are often used when managed by professionals.
What does it cost to cover my employees?
Plan design has a lot to do with what the plan costs. If you are the only participant the cost is the contribution plus administrative/actuarial fees. Adding employees increases the contribution. The actuary or consultant will illustrate what the cost is likely to be when the plan is being designed. Generally, you should expect to receive 60% to 90% of the benefits. The older and more highly paid your employees are, the lower the percentage you will receive. Therefore, these plans work best when the work force is younger and less highly paid on average than the owners and officers.
Give me an example of what it costs for an employee.
Let's take a plan that will provide a pension of 100% of your pay at retirement. Your employee is age 30 earning $30,000 per year. Your contribution on her behalf is $4,000 per year. Contributions in a defined benefit plan are not the pension, therefore do not assume that the employee is entitled to $4,000 today. This concept is the hardest to understand because most people want to relate the yearly expenditure as the actual cost. Here is some math that shows what the cost might be.
Let's say this 30-year-old employee works for you for three years. You contributed $4,000 x 3 = $12,000. Assuming you are in the 40% plus tax bracket, your after tax cost is $7,200. All money contributed to a pension plan is tax deductible. Think of it this way, if you took home the $12,000 you would be left with $7,200. But we are not done.
The assumption: The employee terminates employment after three years. How much money is she entitled to?
The formula: is derived based on the actual years worked over the total years to retirement. This is called the "accrued benefit". Based on the plan formula, the employee was scheduled to receive a pension at age 65 of $2,500 per month. Since she only worked for three years, she is entitled to 3/35ths or .086% of the projected pension (3/35 = 3 years of service and 35 years until retirement), which is $215 per month at age 65. Large pension plans are often designed to pay the $215 per month for life at retirement. Small companies may not be around that long so most plans convert the pension to a current cash amount. The current cash amount is called the "present value of the accrued benefit" (PVAB).
The math: What is the PVAB of $215 per month at 5% interest due in 32 years? The answer: is $6,682.
In this example, the cost is $6,682 and not the $12,000 that you put in the plan towards her retirement. As an employee remains in the plan over the years the more closely the contribution will equal the PVAB, assuming you earned at least 5% on the money. But wait, there may be more savings if there is a vesting schedule. Vesting is the amount of the PVAB the employee is entitled to. If there is a typical six year vesting schedule after three years, then the employee gets 40% of the PVAB or .40 x $6,682 = $2,673.
You contributed and took a deduction for $12,000 over three years and only paid out $2,673. There is more. The money was at work earning at least 5% so the $12,000 grew to $13,240. $13,240 - $2,673 = $10,567. The $10,567 is called a forfeiture and is used to reduce future contributions or to pay administrative fees.
Companies that have a fair amount of turnover plus a young employee population with an older owner will find the cost of a Defined Benefit to be lower than other types of plans.
Why don't more companies have these plans?
Large brokerage firms and insurance companies do not have the expertise to design and maintain these plans so they are not marketed like 401(k) plans. Also, most businesses do not understand how the cost is derived so they are afraid to commit to the plan. You have to be willing to commit to a contribution for at least five years, and understand that if you can not live up to the commitment that the plan must be redesigned which increases the administrative cost. You need to appreciate that as an owner you are getting a benefit many times more valuable than a typical retirement plan. The cost of operation is almost always incidental to what you will receive at the end. The only people not satisfied with Defined Benefit plans are those that stop them almost as soon as they establish them. Then again it is part of plan design. If you know you will stop the plan in a short amount of time this information will help the actuary design the plan to give you the proper outcome.
How do employees relate to the plan?
Young, short-service employees don't find much value in a benefit that is promised when they retire. For these employees, we recommend a 401(k) Plan. However, your key employees will find the Defined Benefit Plan extremely valuable. You are promising them a guaranteed pension if they stay with you. Surveys have shown that if an employee has his/her retirement income taken care of, he/she will be a more productive employee.
What else do I need to know?
We design the plan to benefit you as much as possible, in most cases 60% to 80% of the contribution if you have employees. An Enrolled Actuary certifies our plan designs and our plan document is pre approved by the Internal Revenue Service. Yearly, the plan is
These few pages won't make you an expert on Defined Benefit Plans but, hopefully, we have taken the mystery out of the concept. Please call on one our consultants to assist you in a plan design that will make sense for you.
reviewed to be sure you are on schedule. Changes to increase or decrease the benefits or contributions can be made along the way. This is an important feature to our plans. If your business is not making money, the benefits can be cut back. Conversely, if you need more tax deductions, the plan benefit can be increased. Adjustments are made annually for changes in employees, salaries and plan earnings. We prepare all necessary government filings and arrange to pay benefits for those employees that terminate during the year.
How do I find out if a Defined Benefit Pension plan is right for my company?
Retirement plans are based on age, salary and years of employment. If you provide us with a list of all employees with their date of hire, date of birth and W-2 wages, we can do a study. The cost of the study is $500, which will be credited toward the installation of the plan if you decide to go forward. Installation fees are generally $1,200 for small plans.
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