This Is Not Granddad’s ‘Defined Benefit Plan’

One type of retirement plan that was popular in your grandfather’s day, or maybe your father’s day, is making a comeback. It’s a “defined benefit plan”—really, a traditional pension plan. Why the revival now? With a defined benefit plan, you can generally build a retirement nest egg faster than you can with a 401(k) or other kind of “defined contribution plan.” For this reason, defined benefit plans often appeal to older business owners or managers who are in a position to call the shots. But the plan does come with some potential drawbacks.

Basic premise: A defined contribution plan specifies an annual amount to be contributed on behalf of each participating employee. In contrast, a defined benefit plan specifies the amount of the benefits that will be paid to plan participants when they retire. It allows for large contributions over a relatively short period of time.

How is the amount of benefits determined in a defined benefit plan? Several methods may be used, but the specified benefit is generally predetermined by a formula based on an employee’s earnings history, length of service, and age. Commonly, the formula reflects that worker’s final salary. Under this formula, benefits are based on a percentage of average earnings during a specified number of years at the end of the employee’s career.

As with defined contribution plans, the tax law imposes specific limits on contributions, which are indexed for inflation. With a defined contribution plan, the annual deductible additions for 2013 can’t exceed 25% of the participant’s compensation or $51,000, whichever is less. The annual dollar benefit for a defined benefit plan in 2013 can’t be more than 100% of the participant’s average compensation for that person’s three highest consecutive years of earnings, or $205,000, whichever is less.

With either a defined benefit or a defined contribution plan, the maximum amount of compensation that may be taken into account for plan purposes is limited to $255,000 in 2013. Thus, even with a defined benefit plan, the retirement plan benefits of a company’s highest earners are likely to be watered down a bit.

In addition, be aware of other special limits on “top-heavy” retirement plans. A plan is treated as being top-heavy if more than 60% of the benefits go to the company’s “key employees.” That includes anyone who qualifies under one of these classifications for plan years ending in 2013:

 

  • A company officer earning more than $165,000.
  • An employee who owns 5% or more of the company.
  • An employee who owns 1% or more of the company and has an annual compensation of more than $150,000.

 

Employees who don’t fall under these definitions are treated as non-key employees.

Among other technical requirements, a defined contribution plan that is top-heavy generally must provide contributions of at least 3% of compensation for each plan participant who is not a key employee. In the case of a defined benefit plan, the minimum contribution generally must represent at least 2% of a non-key employee’s compensation.

Caution: Of course, there’s no such thing as a free lunch—at least not where tax laws are concerned. The main disadvantage for older business owners is that a defined benefit plan must cover all eligible employees as well the top brass. That’s why many companies have steered away from traditional pensions plans towards 401(k) plans, for which employees make most or all of the contributions on their own. Also, it may be more costly for a company to operate a defined benefit plan than to have a defined contribution plan. The plan is legally required to ensure that it is properly funded. One plus, though, is that benefits are insured by the Pension Benefit Guaranty Corporation (PBGC). The PBGC doesn’t insure defined contribution plans.

Last but not least, know that today’s defined benefit plan isn’t your grandfather’s plan. You don’t have to settle for the traditional pension plan format. Instead, you can choose from several variations or hybrid plans combining some of the elements of defined contribution and defined benefit plans. Hybrid alternatives include plans that are referred to as age-weighted plans, new comparability plans, target benefit plans, and cash balance plans.

Is a defined benefit plan right for you and your company? Please let us know if you want to investigate your options.

Comments are closed.

BNY Research and Commentary

Related Articles

Global Markets

The Time For Emerging Markets

Emerging markets are diverse and we see the growth prospects for certain countries as remaining excellent (and, in our view, sustainably so) irrespective of commodity prices and consequent global trade gyrations. We believe there are many heavily under-penetrated sectors providing...

Read More: The Time For Emerging Markets
Market Commentary

Mid-Year Market Commentary

Investors entered 2017 with the anticipation that the Trump administration would usher in a period of fiscal stimulus which could reaccelerate economic growth.

Read More: Mid-Year Market Commentary
Investment Insight

Common Misconceptions About the Current Bull Market

Jeff Mortimer’s September Investment Update discusses common concerns about the current bull market and how misconceptions can cause investors to miss out on opportunities.

Read More: Common Misconceptions About the Current Bull Market
Asset Allocation

The Mounting Case For EAFE Equities

We think the U.S. election outcome and a shift in global sentiment have created pockets of compelling investment ideas in Europe and Japan. We see a resumption of trends that began to play out over a year ago when U.S....

Read More: The Mounting Case For EAFE Equities
Economic Insight

Where In The WEO Are We?

Twice a year, staff of the International Monetary Fund (IMF) rolls out forecasts for over 190 economies for the next five years.

Read More: Where In The WEO Are We?