Retirement plans may be categorized as either defined benefit or defined contribution plans. The so-called hybrid plans, such as cash balance plans, contain characteristics of both plans but fall under the defined benefit plan category. The characteristics of each type of plan as well as the pros and cons of each plan are outlined in detail below.
A defined benefit plan (“DB”) is a plan that promises to pay a predetermined benefit at retirement. Retirement benefits must be definitely determinable which means the benefit payable to an employee is based on a formula set forth in a plan document and often takes into consideration service and compensation. The annual contribution to the DB plan is determined by an actuary, and can vary from year to year depending on how much is needed to fund the benefit. Benefits are generally insured by the Pension Benefit Guaranty Corporation (PBGC), a federal agency, in the event of plan termination with an underfunded plan. The commitment of the employer is to satisfy funding requirements to provide retirement benefits. If the plan is fully funded (i.e., when plan assets exceed plan liabilities), no contributions may be required. The employee does not bear the plan’s investment risk.
There are no individual accounts (except for the hypothetical accounts of a cash balance plan) and all assets must be pooled. This type of plan generally favors older employees and, in most situations produces the highest tax- deductible contribution.
A defined contribution plan (“DC”) is an individual account plan, the most common being the 401(k) plan. Annual contributions to a participant’s account are based on the formula contained in the plan, and for 401(k) plans, an employee’s salary deferral contributions. Retirement benefits are based on the value of the accumulation in the account. Investment performance directly affects the value of the ultimate retirement benefit. The employer’s commitment is to make annual contributions, not to provide a guaranteed retirement benefit. There is no guarantee as to what the value of the account will be when the participant reaches retirement. The employee bears all the investment risk in this plan which generally favors younger employees because of the time factor in accumulating an account balance. The way contributions are allocated can vary. Some possible allocation formulas include:
• Pro rata based on compensation
• Integration with social security
• Points based on compensation, age and service
• Based on job description or other employee classifications
• Cross-tested, requiring general discrimination testing
Cash balance plans offer some of the features of both DC and DEB plans. Participants are still guaranteed a minimum benefit and can collect a life annuity upon retirement — which provides more security from investment risks and longevity risks than a 401(k)-type individual DC account. Each participant is credited annually with a pension credit in accordance with a plan formula (usually a fixed dollar amount or percentage of pay) and an interest credit on the employer contributions, but instead of controlling an individual account and making one’s own investment decisions, it is all done by the employer. Note that the employer still bears actuarial risks under this arrangement, not the employees or the retirees. If investments fail to produce the guaranteed interest credit rate, the employer is likely to be “left on the hook” one way or another unless the plan accumulates a loss reserve from excess earnings in the “good” years. Taxpayers still underwrite this program in most cases as it provides one of the highest contributions and tax deductions, especially when combined with a 401(k) plan (combo plans). Cash balance plans work especially well where the owners (or principals) and other key employees are more advanced in age compared to the rank and file employees.
Pros and Cons of Defined Benefit Plans - These plans are often referred to as “traditional” pension plans. Employees covered by these plans don’t have to worry about saving for retirement. These plans are typically generous, and long-term employees are rewarded with pensions that allow them to supplement their retirement savings and live comfortably in retirement. These plans also place a financial burden on employers. Since the return on the fund’s investments is uncertain, it’s possible that employer contributions may not be sufficient to meet its obligations to present and future retirees. Normally, the fund is evaluated each year to determine the level of funding required to fund the plan’s shortfall. When investments perform poorly, the employer’s contributions need to increase. Conversely, when plan investments exceed expectations, the plan can reach a fully funded position and no contributions would be required. The DB plan allows for portability of benefits at retirement, as many offer a lump sum provision in the distribution of benefit, such as in the cash balance plan).
Pros and Cons of Defined Contribution Plans - Since the performance of an investment will always carry some uncertainty, the employees can never be 100% confident of their benefits at retirement derived from a DC plan. The employer’s obligation can be readily calculated each year, and does not fluctuate in accordance with the fund’s performance. This provides a significant advantage to employers versus a DB plan. This also means that employees bear the risk of their retirement funds not providing them with sufficient retirement income. When this occurs, the employee may be faced with a decision to delay retirement or find another source of supplemental income at retirement. The portability feature is also commonly found in DC plans as employees are allowed to take their vested account balance with them upon termination of employment or retirement.
At Benefits 21, we have knowledgeable professionals and systems to determine the best plan for you based on your firm’s long-term financial objectives.