The defined benefit plan was the way corporate America first met retirement needs of employees over the age of 65. For more than seven decades, it has been used to provide working-life income during an employee's retirement years. However, changes to employee demographics, federal law and more detailed and complex reporting requirements in the 1980s and 1990s have diminished its popularity while defined contribution plans (eg. 401(k) plans) gained favor. During the past 30 years, the 401(k) plan has captured the vast majority of the corporate retirement plan market-and for good reason.
For example, these plans allow in-service withdrawals and loans, enable employees to move their vested balances from one employer to another, and reduce potential cash flow problems for employers and employees because of their consistent level of contributions. In many situations however, defined contribution plans fail to provide employers with ample tax deductions, do not encourage employees to form long-term relationships with their employer, and may not generate adequate levels of retirement income for employees, particularly in the face of inflation and stock market fluctuations. This is why the merits and advantages of the defined benefit plans (including cash balance plans) should be considered when designing any retirement program.
In many instances, defined benefit plans are ideal for companies whose objectives include the following:
- Maximize the employer's tax deductible contribution. The defined benefit plan provides the highest contribution and tax deduction. The contributions are calculated based on the employees' age and compensation. The older the employee and the more compensation (up to IRS limits) the larger the contribution required for the employee. These plans are not subject to the 25% of compensation employer deduction or participant contribution limitations. Under PPA-2006, the contribution range is fairly large. The employer may deduct up to 150% of plan liabilities reduced by the plan's assets.
- Defined benefit plans work well with owners or principals more advanced in age than the other employees. They can even be set up for single employee businesses. The plan can be used with any number of owners, key employees and other employees. Here is an example showing how this type of plan can benefit your company:
|Summary of Contributions|
As a percent of Total
|Summary of Tax Savings|
|Total Contribution for Owner||$147,500|
|Less Estimated Income Tax Savings||-73,530|
|Net Cash Paid Out||89,870||-89,870|
|Owner's Contribution Paid By Tax Savings||$57,630|
This example shows that the Owner is receiving a contribution of $147,500 but only paying out a net cash amount of $89,870. Also, the rest of the employees are receiving contributions totaling $15,900. Of course, the results will vary as the demographics of the particular situation change.
- The defined benefit plan is the only way to provide income to employees and their spouses that, combined with Social Security, adequately maintains their standard of living. Post-retirement income is measured by "income replacement ratios" or the percentage of final pay replaced by pension and Social Security payments. Many participants in 401(k) plans will generate retirement income that is inferior to participants in defined benefit plans, in large part because they do not take advantage of the maximum contribution levels, but do utilize the in-service withdrawal and loan options. You can retire and think you have plenty of cash set aside in your 401(k) plan, only to fall victim to a bad financial market such as what happened in 2008, when many people lost up to 50% of what they had saved over twenty or thirty years.
- Pensions automatically provide monthly income for the life of the participant and the beneficiary with no need for them to purchase annuity contracts or make investments decisions about underlying assets. Also, substantial survivor income continues to the spouse after the employee dies without requiring the beneficiary to deal with large lump-sum payments and difficult investment decisions.
- Recruit and retain career employees. Once communicated, the guaranteed retirement income is a desirable benefit that helps to hire new employees or retain current staff to retirement. Sending a message that their pension will effectively augment their shrinking Social Security benefits when they retire can be a powerful tool to build a quality workforce and/or reduce employee turnover.
As corporate America moves ahead and baby boomers retire, it will devote more attention to the changing needs of employees, prompting managers to reconsider all types of defined benefit and defined contribution plans. Further, responsible retirement planning will demand a serious review of plan results. Is meaningful retirement protection being provided and, if so, at what cost? Clearly, in many cases, the defined benefit plan will be a very important part of retirement planning for its many advantages.
For any questions about the content on this article, please email Michael Ibrahim at MIbrahim@FriedmanLLP.com or contact your engagement partner.