What Is a Defined Benefits Plan?
Defined Benefit Plans are employer-sponsored retirement plans. They consist of a pre-determined benefit amount that has been calculated based on several variables in the beneficiary’s life, such as age, health, and cost-of-living adjustments. Defined benefit plans are best suited for individuals who wish to retire early or have a short investment timeframe in mind for such plans.
The advantages of defined benefit plans are that they are predictable, meaning the final payout from the plan does not depend on investment returns. They are also flexible and provide tax benefits to employers. The disadvantages of defined benefit plans are that they are complex and time-consuming to create and can be expansive to maintain.
Defined benefit plans are popular with wealthy small businesses that have few employees. They are also popular with CEOs of companies who are on the verge of retirement or have a fairly short timeframe for investment in such plans. The popularity of such plans stems from their flexible nature. Employee contribution is voluntary. The payouts from a defined benefit plan can be staggered over a period of time, such as an annuity, or they can be a lump-sum. In addition, businesses of any size and number of employees can set up and operate such plans.
Generally, defined benefit plans require complex actuarial calculations that take into account the current age of the employee and their estimated lifespan. Or, they can also be crafted as simple plans in which payouts are decided based on the employee’s years spent in service of organization. Regardless of the design considerations, the actual plan document must be vetted and signed by an actuary.
Defined benefit plans have contribution limits and cannot exceed 100% of the participant’s average compensation for their highest three consecutive calendar years. This figure should not exceed $230,000 for 2021 and 2020. Distributions for a Defined Benefit Plans are not made before the age of 62.
How to Set Up and Operate a Defined Benefit Plan
The process to set up and operate a defined benefit plan begins with an assessment of goals for the plan. Several questions must be answered at this point. For example, what is the expected payout that employees or beneficiaries of the plan expect to receive and for how long? What is their current compensation and how much can the employer contribute on an annual basis to the plan? Are these contributions to be made in a single payment or should they be made periodically over time?
Once the plan’s broad design is in place, the actual numbers are put in and vetted and signed by an actuary. Finally, the business’s senior management or executives sign the plan.
The next step is to find a financial institution to act as trustee for the plan’s assets. Banks and brokerages are examples of institutions approved to operate a defined benefit plan. The assets for a Defined Benefit Plan have a trust identification number assigned to them. Companies with Defined Benefit Plans are required to file Form 5500 with a Schedule B annually.
The IRS defines Defined Benefit Plans as their “most administratively complex plan” because it has instituted a number of rules related to the plan’s design and functioning.
Advantages and Disadvantages of Defined Benefit Plans
The main advantage of Defined Benefit Plans is that their flexibility. Businesses of any size can offer Defined Benefit Plans to employees. They can also be combined with other retirement plans to maximize retirement income. The vesting or ownership can be immediate or spread out over seven years.
Defined benefit plans also offer tax benefits to employers because they allow them to contribute more than the usual amounts allowed in retirement plans and claim greater tax deductions versus regular retirement accounts.
There’s also the benefits accruing from predictability. Whereas the final amount in retirement accounts cannot be predicted and is dependent on market performance of investments, defined benefit plans have a predictable outlay and outcome. Hence, it becomes easier for beneficiaries or employees to plan for their retirement because the final amount does not depend on returns from investing assets.
Despite their advantages, however, defined benefit plans have declined in popularity over the years. A 2019 Employee Benefits Report found that only 21 percent of employers offer a traditional defined benefit plan open to all employees.
One of the main reasons for this is the fact that such plans are complicated to set up and require ongoing maintenance that is far more expensive as compared to other, conventional retirement income instruments. Again, the all-in cost of fees is 0.45% of total invested assets for a 401(k) according to research. Therefore, if you have $100,000 invested, then you will end up paying $450 as annual fees. A defined benefit plan at a provider like Schwab could incur a minimum of $1750 annual fee for a single person and more, if additional employees are added.
Defined benefits plans also cannot be retroactively amended, meaning companies cannot change payout amounts or benefits and are required to adhere to the stated benefits in the plan document. This can be a problem, if investment gains from assets are not able to match up to the promised benefits. Excise taxes are applied if contributions are above or below the amount specified during the plan’s creation.
Defined Benefits Plans FAQs
About the Author
True Tamplin, BSc, CEPF®
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True contributes to his own finance dictionary, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.