Defined Benefit Pension
- This works in reverse from profit sharing, 401(k) Salary Deferral Only, and 401(k) with Matching Contributions plans (click the links to read their descriptions).
- In a defined contribution plan, the amount going into the plan is defined and the amount available for retirement is the account value at retirement. It is based on the contributions and the investment performance.
- In a defined benefit plan, the amount available at retirement is defined and the amount that the company contributes equals the amount needed to arrive at the target retirement accumulation. Therefore, if investments perform well, the company needs to contribute less than if the investments do not perform well.
- Another way of looking at it, is that in a defined contribution plan, the contributions are limited. In a defined benefit plan, the amount accumulated at retirement is limited, but the amount contributed to arrive at the accumulation is not limited.
- The amount of contribution that is required each year is determined through actuarial calculations.
- In the second and later years of a defined benefit plan there is also a maximum deductible contribution that is calculated. It is often substantially higher than the minimum funding amount.
- Contributing the minimum funding each year will likely result in the underfunding of benefits since the actuarial factors used to determine the lump sum settlement of benefits, or to purchase an annuity are different than the actuarial factor used to determine the minimum funding.
- In recent years many defined benefit plans have terminated or have frozen the accrual of benefits because of the high funding costs for these kinds of plans
- A frozen plan often suggests a plan that is underfunded and cannot yet terminate and pay full benefits
- At a given level of benefit, the contributions required to fund the benefits of older employees are larger than that required to fund similar benefits for younger employees. This is because there are fewer contributions to retirement age for older employees and also less time for the money to grow. This disparity in funding can be very significant with large age differences
- Small businesses, including small professional groups, may find defined benefit plans particularly attractive since these plans might provide much greater contributions for principals (relative to those for other employees) since the principals are often older, on average, than the other employees.
- Contributions for older principals can approach and even exceed $200,000 in a particular year.
- Minimum contributions determined actuarially and have little room for variance. Some flexibility can be achieved through a plan design that increases the sensitivity of benefit accrual to changes in compensation. Amending the benefit formula can also affect funding, although frequent amendments to the benefit formula will invalidate the plan.
- Defined benefit plans can also be “fully insured” under Code Section 412(e)(3).
- Funded entirely by annuity contracts (sometimes in conjunction with life insurance) that meet specific requirements of the tax code
- Do not require actuarial certification of calculation since the internal rates of the insurance company govern
- Often result in larger initial contributions than other defined benefit plans because of the insurance company’s internal rates
- Ultimately limited to the same retirement accumulation as other defined benefit pension plans
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