Increased benefit and
compensation limits included in the Economic Growth and Tax Relief
Reconciliation Act ("EGTRRA") as well as the downturn in investment markets
have refocused attention on defined benefit plans as alternatives to defined
contribution plans. The defined benefit plan design can offer larger
accumulations at retirement for some small business owners with lower costs
for younger, non-key employees. However, there can be negative consequences
that must be explored before such a plan is adopted.
What is a Defined Benefit Plan?
A defined benefit plan is a retirement program that promises a specific
benefit to participants at retirement age. The benefit is normally defined
as a monthly pension equal to a percent of pay (flat benefit plan) or a
percent of pay times years of service (unit benefit plan). The compensation
used in calculating the monthly benefit is usually based on the highest
three or five year average.
In a defined benefit plan, the plan sponsor contributes whatever is
necessary to reach the promised payout at retirement age. An actuary
converts the monthly annuity payable at retirement to a lump sum. The
actuary then determines each year what amount is required as a contribution
based on the current value of plan assets and the date those benefits are
due to each participant.
The contribution can vary depending on investment returns. Low investment
returns cause higher required contributions, and high investment returns
lower the contribution requirement.
How Does a Defined Benefit Plan Compare to a Defined
Contribution Plan?
The core of the difference between defined benefit and defined
contribution plans lies in who gets affected by the plan's rate of return.
In a defined contribution plan, a participant receives whatever balance is
in his account based on the rate of return in the plan. In a defined benefit
plan, the plan sponsor is taking responsibility for any fluctuations in the
market. The participant must receive a fixed amount and, if the plan's
investments do not earn a rate of return to guarantee that benefit, then the
sponsor must contribute enough to make up the difference.
Because of the nature of the defined benefit plan, the costs are
significantly higher for older employees than younger employees. Assuming
retirement at age 60, the plan sponsor has 35 years to "fund up" the benefit
for a 25-year-old but only 5 years for a 55-year-old. Therefore, a defined
benefit plan can offer significant advantages for an older employer with
younger employees as illustrated below.
Contribution Comparison
A corporation has two non-key employees and two owners. The non-key
employees each earn $30,000 and are ages 25 and 35 on the first day of the
plan year. The owners each earn in excess of $200,000 and are ages 55 and
65. Retirement age is defined as the later of age 60 or five years of plan
participation. The contributions under a defined benefit plan as contrasted
to a 20% of pay defined contribution plan are illustrated below:
The defined benefit plan offers a higher percentage to the owners, and
the dollar amount available for the owners is significantly higher. However,
one of the disadvantages of defined benefit plans is the increased costs for
older employees. If this corporation had a 45- or 55-year-old employee
earning $30,000, the respective costs would be $14,895 and $38,186.
| Cost Comparison |
| Employee |
Defined
Benefit |
Defined Contribution |
| Age 25 |
$2,921 |
$6,000 |
| Age 35 |
$6,153 |
$6,000 |
| Owner 55 |
$145,151 |
$40,000 |
| Owner 65 |
$167,838 |
$40,000 |
| Total |
$322,063 |
$92,000 |
| % to owners |
97.2% |
87.0% |
Accumulation Comparison
Next we look at the amounts accumulated in five years for the example
above. This would be the date that the owners reach normal retirement age
under the plan. For the defined contribution plan we assumed a 6% average
rate of return over all years.
| Accumulation Comparison |
| Employee |
Defined
Benefit |
Defined Contribution |
| Age 25 |
$10,953 |
$33,823 |
| Age 35 |
$26,143 |
$33,823 |
| Owner 55 |
$826,436 |
$225,484 |
| Owner 65 |
$955,611 |
$225,484 |
Administrative Differences
A defined benefit plan must meet more complex regulatory restrictions and
administrative procedures. An actuary is required to certify the annual
costs and calculate the annual valuation of benefits for employees.
Administrative fees are generally higher due to these factors.
Defined benefit plans must pay a premium and report funding levels
annually to the Pension Benefit Guaranty Corporation (PBGC). The PBGC is a
federal entity that insures benefits in most defined benefit plans.
Generally, plans that only cover owners and plans sponsored by professional
organizations that employ less than 25 individuals are exempt from PBGC
coverage.
The PBGC will pay benefits to participants if the funds are insufficient
to do so and the plan sponsor is unable to contribute enough to make up the
difference. The PBGC then goes after the plan sponsor to pay back the
difference.
Benefits Before Retirement Age
In a defined contribution plan, the benefit upon termination of
employment is the vested percent of the participant's account balance. The
vested percent increases with service, generally reaching 100% by the
seventh year.
In a defined benefit plan, the account balance is replaced by the concept
of an accrued benefit. A participant accrues (or earns) a portion of his
projected benefit at retirement each year that he is in the plan. For
example, a participant who will be in the plan for ten years at retirement
might accrue one-tenth of his benefit for each year of plan participation.
Assuming a projected pension of $100 per month, this participant would have
an accrued benefit of $10 per month after the first year, $20 per month
after the second year and so forth. Vesting is then applied to the accrued
benefit.
When a participant terminates, his benefit is defined as a certain amount
payable at retirement age as an annuity. An actuary determines the present
lump sum value of that annuity. If the current value is less than $5,000,
the participant may generally take the distribution in cash (either as a
rollover or a taxable distribution). If the value is more than $5,000, the
default form of distribution is a joint and survivor annuity.
A joint and survivor annuity pays a monthly amount during the life of the
participant and a reduced amount (usually 50%) upon the death of the
participant for the remaining life of the spouse. Both the spouse and the
participant must consent in writing to waive this form of benefit if the
participant wants to take a lump sum or other form of annuity.
Defined benefit plans can offer loans to participants. The maximum
available loan is based on the lump sum value of the vested accrued benefits
of the participants (as opposed to the account balances). In-service
withdrawals before retirement age are generally not available and hardship
withdrawals are not allowed.
Advantages and Disadvantages of Defined Benefit
Plans
The primary advantage of a defined benefit plan is the ability to
accumulate large amounts for older key employees. The plan sponsor can make
deductible contributions to ensure that the benefit is in place no matter
what the market conditions are. Therein also lies the primary disadvantage
of such plans: low market returns can cause an increase in contribution
requirements at a time when the employer may not be able to meet those
requirements.
Employee perception of this type of plan can work for or against the
employer. If the defined benefit plan is presented as a way to protect
employees from market fluctuations and guarantee benefits, the plan may be
well accepted. The current down market would make the plan even more
desirable to them. On the other hand, as benefits are generally illustrated
as monthly pensions payable at a future retirement date, employees may have
difficulty putting a current value on the benefit accruing to them.
Under current regulations, a lump sum payout to a terminated participant
must be calculated using two methods. The first calculation uses and, in a
well funded plan, would come close to the funds that have been put away for
the participant over time with interest. However, the benefit must then be
recalculated using IRS mandated rates which are based on 30-year Treasury
bills. This can result in a payout to a terminated participant that is as
much as 250% of the amount funded. These inflated payouts then lower the
overall funding of the plan and cause higher contributions.
These regulations, combined with current low Treasury bill rates, have
caused many plans to become significantly underfunded. There are several
legislative changes being considered to minimize the impact of this problem,
but a plan currently in existence can find itself paying out amounts far
greater than anticipated to terminated participants.
Who Should Consider a Defined Benefit Plan?
The ideal candidate for a defined benefit plan is a business owner who is
age 40 or older. A plan sponsor with no other employees or only young
employees will have the lowest non-owner costs. The plan sponsor must be
aware that the contributions are mandatory and feel that future cash flow
will support the continuation of the plan. The risks of inflated costs due
to market fluctuations and/or the hire of older employees must be
anticipated.
Add-On 401(k)
Plan sponsors who maintain both a defined benefit and a defined
contribution plan have a maximum deduction limit of the greater of 25% of
eligible payroll or the defined benefit required contribution. Under EGTRRA,
employee contributions towards a 401(k) plan do not count towards this
limit. The result of this change is that employers with defined benefit
plans can add on a 401(k) plan that allows for participant deferrals only
(no employer contributions).
For the plan sponsor without non-highly compensated employees, this would
mean an additional contribution in 2003 of $12,000 if under age 50 or
$14,000 if age 50 or older. If there are common-law employees, the deferral
by highly compensated employees would be limited based on the average
deferral by those employees.
Conclusion
Defined benefit plans can be a valuable tool for retirement planning.
There are additional risks and administrative burdens that accompany these
plans. A plan sponsor who is educated as to the potential pitfalls and
secure in continuing the plan can accumulate substantial amounts within
these plans by retirement age.
[top of page]
|