Traditional Defined Benefit Pension Plan
The Basics: Employer contributes an actuarially determined amount sufficient to pay each participant a fixed or defined benefit at his or her retirement.
How It Works
A. Employer contributes an actuarially determined amount each year to the plan.
B. Employer contributions are tax deductible. TRC Sec. 404 (a).
C. Contributions are not taxed currently to the employee. IRC Secs. 402(a) and
403(a)
D. Earnings accumulate income tax-deferred. IRC Sec. 501(a)
E. Distributions can be tax-favored (eligible for 5-year forward avetaging1 or tolled over into an IRA) at retirement. IRC Sees. 402 and 403
Methods Of Defining The Benefit
A. Level Percentage Plan: Example - The benefit is equal to 50% of compensation reduced by 1/25 for each year of participation less than 25 vears.
B. Step Rate Service Weighted for Prior Service: Example - The benefit is equal to 4% of comeensation for the first five years of service plus 3% of compensation-for all other years7 but not to exceed a total of 15 years.
C. Service Plan: Example the benefit is 2.5% of compensation2 for each year of service. Younger participants may also be favored if the benefit formula is service related.
D. Participation Plan: Example - The benefit is 5% per year of participation with a maximum of 20 years.
E. Top-Heavy Plans: If the present value of the accrued benefits of "key employees" is 60% or more of the total value of all accrued benefits of the plan is top heavy. In that instance the plan must provide you a minimum level of benefits for "non-key" participants.
Additional Considerations
A. Investment of Plan Assets: Investments must be diversified and prudent. Subject to plan provisions, plan assets can be invested in equity products like mutual funds; stocks and debt free real estate; or in debt instruments like T-Bills and CDs. Insurance products like life insurance and annuity policies may also be used.
B. Social Security Integration: Since the employer already contributes to the employee's Social Security retirement benefit, these benefits can be integrated into the benefit formula of the plan.
C. Parties Which are Favored: Usually favors older employees.
Maximum Benefit
Maximum benefit under a defined benefit plan is measured in two ways:
A. Percentage: The retirement benefit cannot exceed 100% of the average compensation1 for the highest three consecutive years of employment. This is reduced by 10% for each year of service less than 10.
B. Dollar Amount: The maximum dollar benefit is indexed at $130,000 per year (1999) for retirement at age 65 or at the Social Security "normal retirement age'7 if later than 65. For earlier retirement this amount is actuarially reduced. Early retirement at age 55 would typically produce a maximum annual benefit of $45,000 - $60,000, depending on the assumptions used and cost of living adjustments. The dollar amount will also be increased for late retirement, subject to the percentage and dollar limitations. Lastly, if the individual has fewer than 10 years of participation at normal retirement age, the dollar amount is reduced proportionately.
First-Year Contributions
A number of assumptions must be made in determining the amount of current contributions necessary to accumulate the future retirement benefit. These assumptions include the following:
A. Interest rate on earnings
B. Annuity rates at retirement
C. Statutory requirements and limits
D. Participants' current ages
E. Compensation increases
F. Death benefits
G. Retirement age
H. Form of annuity
I. IRS Requirements
J. Various government interest rates
Annual Contributions
Year to year contributions wilt fluctuate based on the following:
Annual funding is done on the assumption that each participant will retire. Accrued benefits are earned each year, and if the participant does not work until scheduled retirement he or she will not be entitled to the entire benefit.
Advantages To Employer
A. Contributions are tax deductible.
B. Can reward long term employees with a substantial retirement benefit even though they are close to retirement age.
C. Larger contributions for older employees may reduce corporate tax problem; e.g., excess accumulated earnings, high tax bracket current earnings, etc.
D. Forfeitures of terminating employees will reduce future costs.
E. It can provide employees with permanent life insurance benefits that need not expire or require costly conversion at retirement age.
F. The employer directs investments.
Advantages To Employees
Disadvantages To Employer
A. In low profit years, the employer is often still obligated to make
contributions.
B. Even if profits are low, there is less flexibility with the level of contribution than with some other types of plans.
C. Investment risks are on the employer.
D. Administration costs are usually higher because an actuary must certify as to the
reasonableness of the contribution and
deduction (unless it is a fully insured plan).
E. Under current governmental attitude, employers have much less predictability as to what their contributions will be.
F. Participants often do not 'understand the defined benefit plan as easily as they do other types of plans.
G. If the termination of an over-funded plan causes a reversion of assets to the employer, it will be subject to a 50% excise tax, which can be reduced in some cases.
H. If there are rank and file employees and the plan terminates, there maybe insufficient assets to pay all accrued benefits. The shortfall must be made up by either the business making a contribution (which may or may not be deductible), or by the assets being reallocated from highly compensated participants to those non-highly compensated.
I. When a small plan terminates, it may find that there arc surplus assets which may not
be distributed to participants. Any such surplus returned to the employer is subject to a
50% (20% in some instances) excise tax.
Disadvantages To Employees
A. Younger employees will generally not receive as great of a benefit as they would under other types of plans.
B. The plan concept is more difficult to understand.
C. Starting in the year 2000, the GATT legislation severely reduces the lump-sum distribution available to highly compensated participants, from what would have previously been available.