Defined Benefit Plans
If you worry about financing your future, you’re not alone. According to the 2015 Barometer Poll, retirement is at the forefront of America’s minds.
In fact, almost 67% of individuals polled cited that retirement funding was a chief concern.
We at Storick Group believe that funding your future should to have to be a hassle or stressful, and we aim to make it easier on you by providing you with the tools necessary to make an informed decision about planning for your retirement.
One way we do this is by reviewing – in detail – your options. One of the most common options for retirement savings is a defined benefit plan. In this article, we outline what a traditionally defined benefit plan entails.
What is a Defined Benefit Plan?
A defined benefit plan – sometimes known as a “qualified benefit plan” or a “non-qualified benefit plan” – is an employer-sponsored pension plan in which benefits are doled out based on a specific formula. This formula uses factors such as duration of employment and salary history.
With this type of pension plan, the company sponsoring the plan controls the investment risk and manages the portfolio. The employer will typically be the sole contributor; however, occasionally, employers allow voluntary contributions or require employees to contribute.
Within a defined benefit plan, payouts are dependent upon the return of invested funds. This could be potentially detrimental to employers, as they will need to dip into the company’s earnings if the invested funds come up short. Because of this, the payouts from a defined benefit pension plan aren’t the same for all employees; rather, they are determined by personalized factors like length of time employed. The longer an employee is with the company, the bigger his or her pay-out will be.
Similar to this type of retirement plan is a “tax-qualified” benefit plan. This type of benefit plan provides employees with added tax incentives that aren’t traditionally offered under non-qualified plans. These benefits include the ability to have additional retirement plans and a guarantee that benefits cannot be retroactively decreased. Additionally, a tax-qualified business plan can be an option for a business of any size and requires the annual filing of a Form 5500 with a Schedule B.
Pros and Cons of a Defined Benefit Plan
As with any retirement option, a defined benefit pension plan comes with its pros and cons.
A con for employers is that the accrual pattern of benefits tends to be a “J” shape. This means that the value of the benefits grows slowly in the earlier years of an employee’s career and picks up significantly in his or her mid-career. For employers this means that it is more costly to fund the pension plan for older employees. Than it is to fund the plan for younger employees. This is typically referred to as an “age bias.”
This type of pension plan is less portable than other types of retirement plans. This means it may be more difficult for employees to re-build their nest eggs in case of losing their job. For employees, this plan isn’t all bad: most defined benefit pension plans pay benefits as annuities. Meaning that retirees do not have to worry about outliving their income or taking on the risk of low returns on investments.
For employers, open-ended investment risks within a defined benefit pension plan can be daunting. This is why a lot of companies have made the switch from “defined benefit” plans to “defined contribution” plans in which employees do not benefit if the investment returns exceed the plan’s actuarial estimate.
Because of this type of plan’s reduced portability, age bias and undetermined risks, a defined benefit pension plan is best for careers such as the public sector, in which there is less mobility (employees tend to stay at their jobs) and the employers are large (the public sector has support from taxpayers, so employers take on less of the plan’s financial uncertainty).
Another potential downside to defined benefit pensions are their costs, which require an actuary to calculate. An actuary analyzes statistics to determine insurance risks and premiums. Because there is such an open-ended risk to employers with this type of plan, its cost – and therefore, the contribution – will always be an estimate based upon financial and economic assumptions, including the average age of retirement, average employee lifespan, taxes or levies and estimated returns on the plan’s investments.
Defined Benefit Recap
For employees, a defined benefit plan is a decent choice, as benefits are provided regardless. For employers, the uncertainty of their contribution means that this does not suit all companies.
Let’s review the details of a defined benefit pension plan:
– Employers can deduct and contribute more with this plan than with other retirement options
– The benefit to employees is predictable
– Considerable benefits can be accrued within a short amount of time, potentially even with early retirement
– An employee’s benefits are stable and do not depend on return of assets
– This type of plan is more costly and more administratively complex than other pension plans
– The early retirement option of defined benefit plans can be used the promote certain business strategies
– In the event of excess contributions or if the minimum contribution is not made to the plan, an excise tax will apply.
We know employees and employers have many options when it comes to retirement. A defined benefit pension plan is not for everyone. To determine if this plan is right for your company and employees, give us a call today!