What is the definition of a Defined Benefit Plan? How do they function? Are they similar to other retirement plans? We will answer these and other questions in this article.
Defined Benefit Plans are retirement plans. Unlike Defined Contribution Plans, benefits are not based on the balances of individual accounts. Rather, benefits are calculated using formulas specified in the Plan document.
Similar to Defined Contribution Plans, Defined Benefit Plans are employer-sponsored and generally employer-funded.
Let’s explore this information in more detail.
Another aspect of the Defined Benefit Plan definition is that benefits are based on formulas. The structure of the Defined Benefit formula may vary depending on the objective of the Plan, whether the employer offers a Defined Contribution Plan, the demographics of the workforce, and the industry. Regardless, formulas must be clearly defined. Applicable details include not only how the amount is calculated but when and how the benefit is payable.
In many cases, the benefit formula is a function of both salary and years of service. For example, a monthly benefit could equal 10% of average monthly salary times years of service. Subject to benefit limits, this is a common formula for the owner of the business. As expected, the level of benefit increases as salary and the length of service increases.
Formulas need not be uniform. The Defined Benefit can vary based on employee work location, job classification, or other definable characteristics. The Plan need simply provide clear criteria for which formula applies to a given situation. Benefits that are not uniform may need to satisfy nondiscrimination requirements. These requirements ensure that benefits are “fair” between those that are either owners or highly paid and those who are not.
In terms of payment timing, the default payment age often is age 62 or 65. However, it is common for Defined Benefit Plans to allow for payment before this date. When applicable, there may be conditions, such as a minimum age or service length to qualify. In any case, the benefit usually is reduced for early payment. The extent of the early payment reduction must be specified by the Plan.
The Plan also must clearly explain the way in which benefits are paid. For example, the formula may be defined as a monthly benefit for the employee’s life. Other options, including spousal death benefits, may be required. Additionally, small business plans usually allow a single sum distribution in lieu of monthly payments. Regardless of the options available, the Plan must specify how the default form of payment is converted to any other form of payment. If payment forms are not subsidized, actuarial equivalence may be the basis for this conversion.
Because Defined Benefit Plans are formula-driven, benefits are defined upfront. To pay for these benefits, employers are generally required to fund expected benefits each year. These annual contributions vary each year depending on prior contributions, asset performance, and the benefits that have been earned to date. The required contribution is calculated each year by the Plan’s Defined Benefit Actuary.
On the other hand, Defined Contribution Plans, such as 401(k) Plans, provide benefits based on the balance of each individual. These balances are comprised of invested contributions. Contributions may be employee and/or employer contributions. The final retirement benefit will depend on the amount and timing of contributions and the corresponding asset returns. Unlike a Defined Benefit Plan, no predefined benefit is guaranteed.
Because retirement benefits are predefined, those closer to retirement require higher contributions. This is because, for a given level of benefits, a shorter retirement horizon requires more rapid funding.
For business owners who are 35 or older, defining a large retirement benefit allows significantly higher deductible contributions than other retirement plans. Often as high as $100k to $250k per person! By contrast, Defined Contribution Plans limit annual contributions to a fixed dollar amount.
Defined Benefit Plans are “sponsored” by the employer. This means that the employer is responsible for the administration, compliance, funding, and investing related to the Plan. Although some of these functions can be outsourced to other providers, the employer is still a fiduciary to the Plan.
Traditional Defined Benefit Plan formulas are often defined as monthly annuities payable for life (10% of monthly pay times years of service). However, with Traditional Plans, small business plans generally provide a single sum distribution in lieu of the annuity option. In nearly all cases, the single sum, rather than the annuity option, is chosen.
In contrast, Cash Balance Plan formulas are defined as account balances ($100,000 pay credit every year; pay credits grow at 5% per annum). Note that Cash Balance benefits are “paper balances”. The benefits are accounted for on “paper”, but the assets backing the aggregated balances are pooled. As expected, at payout, a single sum distribution equal to the account balance is available. However, because Cash Balance Plans are Defined Benefit Plans, the Plan also must provide required lifetime annuity options.
In summary, what is the definition of a Defined Benefit Plan? Simply a retirement plan that provides a benefit based on a predefined formula. This structure allows for significantly higher contributions than other types of retirement plans.