How DB plans work
DB plans pay a predetermined amount—a pension—to an employee at retirement or death. This is in contrast to a defined contribution (DC) plan, which specifies a contribution—but not a benefit—amount. DB plans are funded with employer contributions, plus investment earnings, and pension benefits are based on a formula that typically includes an employee’s salary, years of service, and sometimes, age. Each year, the active DB plan participant—the employee—accrues additional benefits according to that formula.
After a certain number of years of service, the benefit becomes vested, which means that the participant becomes entitled, legally, to their pension. Once it’s vested, an employee’s benefit is the employer’s legal obligation. Ultimately, at retirement, a participant can usually choose between lifetime income over just the participant’s life or the life of the participant and a beneficiary (typically, the participant’s spouse). Some DB plans also offer the option to receive a lump-sum payment equal to the value, in today’s dollars, of the participant’s expected lifetime benefit.
ERISA, the Pension Benefit Guarantee Corporation, and DB plans
DB plans are qualified, meaning they’re covered by ERISA—a federal law that protects employee retirement benefits by imposing reporting, disclosure, and legal (fiduciary) requirements. Under ERISA, you have a duty to manage your DB plan prudently and for the exclusive benefit of participants. You also have a duty to contribute enough to your DB plan to fund future payments owed to employees. In exchange, DB plans have the following tax benefits, subject to certain limits, for both your business and your employees:
- Contributions are tax deductible for your business.
- Participants aren’t taxed on pension benefits until they’re paid.
Private sector DB plans are also backed by federal Pension Benefit Guaranty Corporation (PBGC) insurance, for which the employer or plan must pay annual premiums. In 2020, the maximum PBGC-insured annual benefit for participants who retire at age 65 is $69,750.
What types of DB retirement plans are available?
- Traditional DB pension plans promise a specified monthly retirement benefit. Traditional DB plan benefits are typically based on a formula that considers factors such as years of service and salary.
- Cash balance pension plans promise a benefit based on a hypothetical account balance at retirement. Cash balance benefits are typically based on a formula that considers salary (a pay credit) and a reasonable rate of return (an interest credit) on the account balance.
In both cases, the plan sponsor is responsible for funding pledged benefits. The employee bears no investment risk and, usually, no responsibility for contributions. And in both cases, benefits are protected by PBGC insurance, up to certain limits.
Traditional and cash balance DB pension plans are both required to offer a benefit in the form of lifetime monthly income. A plan may also offer an actuarially equivalent lump sum. The benefit options must include a survivor benefit, where the spouse receives the benefit after the participant’s death, which the participant can decline only if their spouse consents. Both types of DB plans set a normal retirement age, usually 65, at which a participant is entitled to full benefits. Early retirees are ordinarily subject to benefit reductions.
Who’s eligible for a DB plan?
Federal law typically sets DB plan eligibility requirements, although you have some leeway. Typically, you can’t exclude:
- Anyone over age 21 or with more than 1,000 hours of service, or
- A part-time employee who worked at least 1,000 hours in the prior year.
You can, however, for administrative convenience, delay participation for up to six months after eligibility requirements are met or until the start of the next plan year, whichever comes first. Earlier entry is also permitted.
Why you might want a DB plan for your business
DB plans can provide a secure retirement benefit to you and your employees, and that benefit can be sizable because you can tie it to final average salary. Additionally, the tax benefits to your business can be substantial because, generally, the annual benefit under a DB plan can be as much as the lesser of 100% of the participant’s average compensation for their highest three consecutive calendar years or $230,000. And since DB contributions must, by law, be sufficient to fund benefits, tax-deductible DB plan contributions can be considerable—much larger than the $57,000 limit (in 2020) for DC plans.
There are other benefits to sponsoring a DB plan:
- You can improve employee retention by stretching vesting out for up to seven years.
- A DB plan’s potential for rapid benefit accrual near retirement can make it an effective way to reward longer service and older employees.
Other considerations for DB plan sponsors
The attractiveness of a guaranteed retirement benefit to employees and the ability to provide relatively large benefits to higher-paid employees funded with tax-deductible contributions are major advantages of DB plans. Because they’re required, by law, to fund and pay benefits, DB plans come with duties. Major responsibilities include:
Costs—Contributions, PBGC insurance premiums, and actuarial calculations are mandatory.
Potential penalties—If you either contribute too much or too little, you’ll owe money (an excise tax) to the IRS.
Actuarial calculations—Pension contributions must, under ERISA, be sufficient to fund promised benefits. Required contributions must be calculated by an actuary.
Investment decision-making—A pension plan must, under ERISA, invest prudently, and the risk of investment underperformance is borne by the employer. Pension investment selection may require the help of a financial professional.
Administrative requirements—Every pension plan needs an administrator to keep workers informed of their benefits; make payments to retirees; make reports to the beneficiaries, the IRS, and the U.S. Department of Labor; and pay PBGC premiums. You’ll probably need to hire a plan administrator to assist with these duties.
Is a DB plan right for your business?
DB plans allow you to make tax-deductible contributions to cover secure and potentially generous benefits for yourself and for your employees. At the same time, DB plans obligate your business to pay promised benefits—and they require actuarial, investment, ERISA, and administrative expertise. The complexity of DB plans means that you should consider consulting an ERISA benefits or financial professional to help you decide if one is right for your business.
The content of this document is for general information only and is believed to be accurate and reliable as of the posting date but may be subject to change. It is not intended to provide investment, tax, plan design, or legal advice (unless otherwise indicated). Please consult your own independent advisor as to any investment, tax, or legal statements made herein.
Prior to establishing a defined benefit plan, including a cash balance plan, plan sponsors should also consider factors such as, but not limited to, the plan’s funding requirements and their impact on the company’s fiscal position, the investments chosen for the plan and their potential influence on the contributions required, and the federal rules that govern this type of plan. Cash balance plan investment losses may increase contributions and incur higher administration costs because the services of an actuary will be required. Minimum contributions may be required, and the plan will need to pay annual premiums to the Pension Benefit Guaranty Corporation to guarantee benefits.
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