August 11, 2021
What Is A Defined Benefit (Db) Plan…Really? What Are The Real Benefits?
A defined benefit pension plan (DB) is a type of retirement plan that promises to pay an eligible employee, also known as a plan participant, a monthly benefit at retirement. The plan may state this promised benefit as an exact dollar amount, such as $1000 per month, a percentage of compensation such as 50% of average monthly compensation, or a percentage of compensation times years of service.
What are the tax benefits of a defined benefit plan?
Like other qualified retirement plans, a DB plan offers tax incentives to both an employer and their employees. Employer contributions are tax-deductible to the employer and tax-deferred until retirement distributions are made to the employee. Depending on a participant’s age and compensation amount, this type of plan can allow for employer contributions that exceed the limitations of defined contribution plans, such as a 401(k) or profit-sharing plan. In addition to enhanced benefits, a DB plan may be combined with a 401(k) or profit-sharing plan to allow for even larger contributions.
As mentioned above, retirement benefits under a DB plan are based on a formula. When designing a DB plan, a retirement plan consultant will consider the age and compensation demographics of an employer’s workforce and the desired funding level, which is generally the amount the employer can afford annually. Based on this information, a benefit formula is developed.
For many plans, an employee’s retirement benefit is calculated by averaging the employee's earnings over a period of time. Generally, we use the highest average compensation for three consecutive years.
The “cost” or contributions necessary to fund the benefits are not easily calculated, because of the myriad of rules the government requires us to use. The government also requires an actuary certified by the Internal Revenue Service to approve the calculations. An actuary is a professional licensed by the government that has passed many tests in mathematics and statistics. The actuary also must be an expert in the rules set forth by the government under ERISA.
How are contributions determined?
On an annual basis and with the assistance of our actuary, we calculate the current and future benefits that are projected to be paid from the plan and determine what amount needs to be contributed to the plan to fund those projected benefits.
Contributions are actuarially determined by taking into consideration the employee’s life expectancy, normal retirement age, government interest rates, and the monthly retirement benefit amount.
Almost all DB plans are funded exclusively by employer contributions and unlike 401(k) plans, investments are pooled. In other words, individual accounts are not allowed. Typically, assets are invested by the plan trustees with the assistance of financial professionals.
Participants have no discretion to direct their investment, as the investment risk is borne by the employer. If assets increase above the assumed actuarial interest rate (interest rates mandated by the government), the employer will contribute less into the plan. The reverse is also true if assets underperform the assumed actuarial interest rate, the employer is responsible for making up the shortfall.
DB plans do not have contribution limits. The contributions are a function of a participant’s age and compensation, along with the application of the benefit formula. For example, younger and older paid participants will generate lower contributions. Conversely, older, and more highly compensated employees will generate larger contributions. We often pair the DB with a 401(k)/profit sharing plan. Government nondiscrimination rules work in favor of employers, with two plans reducing over the cost of having just one DB plan.
There are benefit limitations defined by the IRS and these limitations are stated as an annual benefit payable at normal retirement age. Such a maximum can be as high as $230,000, adjusted periodically by the cost of living. This is a maximum annual benefit, not a maximum annual contribution.
Small business owners will find that if their budget allows they can make contributions of 5 to 6 times the amount they save in a combination 401(k) profit sharing plan. They can keep their 401(k) profit sharing plan if they have it in place and add the DB. Total contributions of $200,000 to $300,000 are available depending on the owner's age. Most of these contributions accrue to the owners while giving their employees an affordable benefit.
When must the employer deposit contributions into the plan?
Contributions to a DB plan can be deducted for a taxable year if the contribution is deposited to the plan no later than the due date for filing the tax return for that taxable year (including extensions). To meet the minimum funding requirements, the plan must be funded no later than 8½ months following the plan year end. For example, a December 31 plan year end would require funding no later than September 15th.
Benefits under the plan are paid upon the occurrence of a distributable event. Such events may include:
Reaching Normal Retirement Age
Termination of Employment
A DB plan allows different payment options and they include:
Single life annuity – A life-long, fixed monthly benefit
Qualified joint and survivor annuity – A life-long, fixed monthly benefit. Upon the employee’s death, the employee’s surviving spouse will continue to receive benefits in an amount equal to at least 50% of the employee’s benefit until their own death
Lump sum payment – A payment of the entire present value of an employee’s accrued benefit
Each employer’s plan design will determine what options are available to employees.
Typically, employees will be offered the option of purchasing an annuity or taking a lump sum distribution equal to the present value of the accrued benefit accumulated at the time of the participant’s distribution. If an employee elects the option of purchasing an annuity, it is the responsibility of the plan sponsor to get quotes from annuity companies and eventually purchase the annuity.
The plan actuary will determine each employee’s accrued benefit and the present value of that benefit. In addition, the plan’s vesting schedule will be applied to that benefit. Employees are always entitled to their vested, accrued benefit, earned to date. However, the plan design will determine how and when an employee is entitled to payment.
Accrued Benefit: The concept of an accrued benefit can be difficult to understand. Below is a simple example of how an accrued benefit is determined.
An employee who is age 55 and earns $1,000 per month (compensation). The plan says they retire at age 62, known as the normal retirement age or NRA. The retirement plan has a benefit formula of 100% of compensation. The plan vests at 20% per year starting in the second year of service.
If the benefit to be received in 10 years from age 52 to 62 is $1,000, then the employee earns 1/10th of the benefit each year. After year 1 the employee has earned the right to $100 (1/10 x $1,000), year 2 = $200, and so forth. If the employee terminates in year 2, he/she would have an accrued monthly benefit of $200. We would then apply the vesting schedule (20% at year 2) resulting in a benefit of $40. This benefit would be paid to the participant monthly once the participant attains the NRA of 62.
Although many defined benefit plans only offer a monthly pension at NRA we design plans to offer employees a lump sum payment upon termination of employment. This being the case, the plan actuary would calculate the present value of receiving a benefit of $40 per month at age 62 for this participant. This is called the present value of the accrued benefit (PVAB). The participant would be eligible to take this lump sum equivalent and roll it into an IRA or take the funds as a taxable distribution.
Like most qualified retirement plans, filing Form 5500 is required. In addition, a DB plan requires certification by an actuary and preparation of a Schedule SB that must be attached to the Form 5500. Other filings and forms may be required depending on the scope and size of the plan. You will see terms such as AFTAP and PBGC. These require additional fees and premium payments because more calculations and certifications are needed.
This type of plan is suited for businesses with consistent, positive cash flow, and highly-compensated owners and executives in their peak earning years.
Plan provides a predictable benefit
Benefit accumulations at retirement have the potential to exceed $2 million
Employers are allowed to contribute more than they would be allowed to contribute under other types of retirement plans
Employer contributions are tax-deductible
Employer contributions are tax-deferred until retirement distributions are made
Can be combined with other tax-qualified retirement plans
Distributions may be rolled to an IRA
Vesting can be immediate or graduated
Forfeitures are used to reduce future employer contributions
Any business entity of any size can sponsor a DB plan
Annual contributions are required. An excise tax applies if the minimum requirement is not satisfied
Assets are pooled and trustee-directed. There are no individually directed accounts
Benefits cannot be retroactively decreased
Distributions are based on actuarial assumptions, not account balances
Trust fund earnings directly impact future employer contributions
One Owner Businesses can have a Defined Benefit Plan
You can be self-employed or an employee of a one-person corporation and have a DB plan. If the employer/employee is a high-income earner and is generally age 45 or more a solo DB plan alone or paired with a 401(k) plan can help provide significant retirement savings.
Cash Balance Pension Plans (CB)
More and more we hear the term cash balance (CB) plan as if it was a new kind of retirement plan. Actually, it is a defined benefit plan that creates a “hypothetical account balance” for each plan participant so it looks like a 401(k) or profit sharing type of plan.
We back into the defined benefit formula based on how much money each owner wants to contribute to the plan. It is actually more complicated to do it this way but solves many issues when there are multiple owners of varying age. Like a DB you accrue a benefit and both the DB and CB cannot exceed a benefit of 100% of compensation up to the current government limit.
Please contact your BEI plan consultant to review various design possibilities to achieve your retirement goals.
Author: Robert Gorelick, APA, and Founder Benefit Equity Inc.