Defined Benefit Plans

What is a Defined Benefit Plan?

Many people are familiar with the mechanics of determining a participant’s benefit and contributions under a Defined Contribution (DC) Plan, such as a 401(k) or Profit Sharing Plan. However, determining benefits and contributions for a Defined Benefit Pension Plan (DB Plan) is more complex and less intuitive. Usually a small company will sponsor a DB Plan in order to obtain higher contributions than can be provided by a DC Plan.

Under a DC Plan, contributions are allocated based on a written allocation formula contained in the Plan document. An account balance, which equals allocated contributions plus investment earnings, is maintained for each participant. A participant’s plan benefit is his vested account balance.

Under a DB Plan, the company promises to give each participant a benefit at retirement. The benefit is calculated using a mathematical formula contained in the Plan document. Typically this formula uses a participant’s average compensation and years of service with the company. Contributions, determined by the actuary are then made to fund the benefit.
Contributions made to a DB Plan are not directly allocated to participants. They are used to fund the benefits of all participants.

Defined Benefit Pension Plans have two advantages over Defined Contribution Plans, namely:

  • Higher contributions. Higher contributions may be obtained by using either a stand-alone Defined Benefit Pension Plan, or in combination with a Profit Sharing or 401(k) Plan.
  • Credit for prior years of service. A Defined Benefit Pension Plan is the only type of Plan for which you can count service, for benefit and funding purposes, prior to the effective date of the Plan. Such service may have to be limited to five years.

Additional features of a Defined Benefit Pension Plan include:

  • Contributions are age weighted (i.e., they are based on the participant’s age when he or she first enters the plan (entry age)). The greater the entry age, the higher the contribution.
  • Contributions are generally required.
  • Investment gains reduce future employer contributions (and vice versa), whereas under a Defined Contribution Plan, investment gains increase participant account balances (and vice versa).
  • Benefits may be insured by and an annual premium paid to the Pension Benefit Guaranty Corporation (PBGC), a quasi United States government agency. A Plan that only covers an owner or only an owner and his spouse, or a plan of a professional employer with less than 26 participants, is not subject to PBGC coverage.

Pension Review Services custom-designs defined benefit plans in order to meet the objectives of the client. Design features include:

  • Formula to determine retirement benefit
  • Eligibility requirements
  • Vesting schedules