A Defined Benefit (“DB”) Plan does not have the direct contribution limits associated with a Defined Contribution (“DC”) Plan (such as Profit Sharing Plan). So, the DB Plan is an excellent option for a company that wants to make annual contributions greater than 25% of covered compensation, without the individual limit of 100% of compensation or $54,000 (2017 limit).
A DB Plan generally favors older participants. Since owners of small businesses tend to be older than most of their employees, this is the plan of choice for many owners of successful small businesses who want to make large deductible contributions to a retirement program.
What follows is some important information about DB Plans. The information is general in nature, and is not intended to be taken as a comprehensive description of the regulations covering qualified plan sponsorship.
Types of DB Plans
There are a number of DB Plan design options available. Some of the options include:
- Traditional DB Plan. This is generally the best option for a small company with one owner (or owner and spouse) as the targeted employee.
- Cash Balance Defined Benefit Plan. This plan is similar to the traditional DB Plan except that participant statements reflect a “hypothetical account balance.” This is a good option when a company has multiple owners who are unrelated, because the benefit accruals under the plan are more accessible to the owners than a traditional DB Plan.
- Tiered Cash Balance Plan combined with a Tiered Profit Sharing Plan. This powerful combination is an excellent option when there are some participants who are older than the owners, and the objective is to set aside the highest percentage of annual contributions for the retirement benefits of the owners.
- Traditional DB Plan combined with a 401(k) Plan. Recent tax law changes make it even easier for a successful small company to combine a 401(k) with a Defined Benefit Plan (traditional or Cash Balance).
Additional information on each of these options is included below.
Why DB Plans Favor Older Participants
A DB Plan favors older participants because the plan promises to pay each participant a specific benefit at retirement. This benefit at retirement has a “lump sum” value. The expected lump sum at retirement is a fixed amount regardless of the participant’s current age (assuming the same compensation and years of participation in the plan at retirement).
Older participants have fewer years for annual contributions to be made to build the required lump sum. So, the closer to retirement the participant is, the greater the annual contributions needed to accumulate the required lump sum.
Further, younger participants have more time for compound interest to work in their favor. Consider two persons with $100 each invested in a retirement account at 10% interest: one is age 55 and the other is age 25. At age 65, the first person’s investment is worth $259. But, with 40 years of compound interest working for him, at age 65 the younger person’s investment is worth $4,526!
These two factors combine to allow older participants to achieve greatly accelerated retirement accumulations when compared to any other option.
DB Plan Basics
A “Defined Benefit” Plan is well named: it is a plan that promises to pay a specific benefit at retirement.
Each year an actuarial valuation is performed to determine the contribution amount necessary to fund the promised retirement benefits. Since the annual contribution is determined by the need to fund future retirement benefits, the contribution amount can be much higher than that allowed by DC Plans.
When the plan is terminated, the distributed amount for each participant is the present value at that time of the promised benefit at retirement. Generally, the participant rolls this amount into an IRA, at which point the rollover amount is subject only to IRA rules.
Some of the more important aspects of a DB Plan include the following:
Determining annual contributions to a DB Plan begins with the benefit formula in the plan document. The benefit formula usually takes into consideration years of participation in the plan and compensation, and defines a monthly amount to be paid to the participant beginning at the retirement age specified in the plan.
The maximum benefit at retirement cannot be higher than 100% of a participant’s highest consecutive 3 year average compensation, with a maximum limit of $215,000 per year (2017 limit).
Because a DB Plan promises to pay future retirement benefits, each year an actuarial valuation is performed to, first, determine the plan’s liabilities (the retirement benefits it will pay in the future), and second, to determine how much needs to be contributed to the plan each year to build the required lump sum to fund this expected stream of payments. This valuation takes into consideration the current plan assets as well as a number of assumptions, including: a particular rate of investment earnings, a rate of salary appreciation, mortality expectations, and other factors.
The set of facts, actuarial assumptions and the valuation method used by the actuary become the basis for making a valuation of the DB Plan. The contribution level that is reflected in this computation is determined by the actuary in accordance with IRS rules and regulations.
Each year, an actuarial valuation is again performed to make sure the plan stays on track to fund the expected retirement benefits promised by the plan.
The plan assumes a rate of return on investments, so the investment risk in a DB Plan is assumed by the employer. If the actual investment earnings are greater than the earnings assumed in the actuarial valuation, then the employer’s cost to fund the plan would tend to decrease. Likewise, if the earnings are less than those assumed in the actuarial valuation, the employer’s costs would tend to increase.
Annual actuarial valuations are used to adjust contributions based on actual plan experience. For this reason, actual experience (investment performance, actual rate of salary increases, change in demographics of plan participants, etc.) will affect future valuations and future contributions (that is, required contributions will tend to vary from year to year).
Each year the actuarial valuation calculates contributions to the DB Plan necessary for funding expected retirement benefits under the plan. The minimum required contribution must be made by the employer.
The contribution deposit is due by the employer’s deadline for filing its business tax return, including extensions (though not later than 8 ½ months after the end of the plan year end). Any amount of a required contribution that is not deposited by the appropriate deadline is subject to a 10% excise tax.
Normal distributions of a participant’s account may occur when the participant terminates employment with the company, retires, or becomes disabled. Generally, participants may “roll” all of the distribution into an Individual Retirement Account (IRA) and continue tax-deferred earnings, or they may elect to take a lump-sum distribution and pay the tax required. Any taxable distribution before age 59 ½ (or age 55, with separation of service) may be subject to an additional 10% excise tax.
Limitations on Certain Distributions
In certain situations, distributions to a participant who is a Highly Compensated Employee may be subject to limitations on distributions or a requirement to collateralize part of the distribution.
Plans Covered by PBGC
The PBGC is an entity within the Department of Labor, the principle purpose of which is to provide insurance coverage to certain DB Plans. The purpose of this insurance is to make sure that promised benefit payments are made.
DB Plans sponsored by most U.S. businesses are required to be covered by the PBGC, with the exception of:
- DB Plans sponsored by “professional service employers” (as defined by the PBGC) that have never had more than 25 active participants.
- DB Plans sponsored by companies with no employees other than substantial owners (or owners and their spouses).
DB Plans covered by the PBGC are required to make annual premium payments to the PBGC. Premiums are based on a number of factors including number of participants and funding status. PBGC premiums are payable to the PBGC, and are independent of Benetech’s fees.