Published Monday, December 10, 2012 at: 7:00 AM EST
One type of retirement plan that was popular in your grandfather’s day, or maybe your father’s day, is making a comeback. It’s a “defined benefit plan” such as a traditional pension plan. Why the revival now? With a defined benefit plan, you can generally build a retirement nest egg faster than you can with a 401(k) or other kind of “defined contribution plan.” For this reason, defined benefit plans often appeal to older business owners or managers who are in a position to call the shots. But the plan does come with some potential drawbacks.
Basic premise: A defined contribution plan specifies an annual amount to be contributed on behalf of each participating employee. In contrast, a defined benefit plan specifies the amount of the benefits that will be paid to plan participants when they retire. It allows for large contributions over a relatively short period of time.
How is the amount of benefits determined in a defined benefit plan? Several methods may be used, but the specified benefit is generally predetermined by a formula based on an employee’s earnings history, length of service, and age. Commonly, the formula reflects that worker’s final salary. Under this formula, benefits are based on a percentage of average earnings during a specified number of years at the end of the employee’s career.
As with defined contribution plans, the tax law imposes specific limits on contributions, which are indexed for inflation. With a defined contribution plan, the annual deductible additions for 2017 can't exceed 25% of the participant's compensation or $54,000, whichever is less. The annual dollar benefit for a defined benefit plan in 2017 can't be more than 100% of the participant's average compensation for that person's three highest consecutive years of earnings, or $215,000, whichever is less.
With either a defined benefit or a defined contribution plan, the maximum amount of compensation that may be taken into account for plan purposes is limited to $270,000 in 2017. Thus, even with a defined benefit plan, the retirement plan benefits of a company’s highest earners are likely to be watered down a bit.
In addition, be aware of other special limits on “top-heavy” retirement plans. A plan is treated as being top-heavy if more than 60% of the benefits go to the company’s “key employees.” That includes anyone who qualifies under one of these classifications for plan years ending in 2016:
A company officer earning more than $175,000.
An employee who owns 5% or more of the company.
An employee who owns 1% or more of the company and has an annual compensation of more than $150,000.
Employees who don’t fall under these definitions are treated as non-key employees.
Among other technical requirements, a defined contribution plan that is top-heavy generally must provide contributions of at least 3% of compensation for each plan participant who is not a key employee. In the case of a defined benefit plan, the minimum contribution generally must represent at least 2% of a non-key employee’s compensation.
Caution: Of course, there’s no such thing as a free lunch—at least not where tax laws are concerned. The main disadvantage for older business owners is that a defined benefit plan must cover all eligible employees as well the top brass. That’s why many companies have steered away from traditional pension plans towards 401(k) plans, for which employees make most or all of the contributions on their own. Also, it may be more costly for a company to operate a defined benefit plan than to have a defined contribution plan. The plan is legally required to ensure that it is properly funded. One plus, though, is that benefits are insured by the Pension Benefit Guaranty Corporation (PBGC). The PBGC doesn’t insure defined contribution plans.
Last, but not least, know that today’s defined benefit plan isn’t your grandfather’s plan. You don’t have to settle for the traditional pension plan format. Instead, you can choose from several variations or hybrid plans combining some of the elements of defined contribution and defined benefit plans. Hybrid alternatives include plans that are referred to as age-weighted plans, new comparability plans, target benefit plans, and cash balance plans.
Is a defined benefit plan right for you and your company? Please let us know if you want to investigate your options.
This article was written by a professional financial journalist for Trustmont Group and is not intended as legal or investment advice.