What is a DB Plan? Exploring Defined Benefit Plan Rules

DB plans are a unique pension structure with complex rules. They are a home run for many business owners.

But they are a horrible option for others!

While 401(k)s and SEPs dominate the retirement conversation, DB plans offer a powerful, tax efficient approach to retirement security. Here’s what you need to know to see if they’re right for you!

Here is a summary of the benefits and downsides of DB plans:

What is a DB plan?

The term DB plan is just short for defined benefit plan. Defined benefit plans promise a specific benefit after retirement for each of the employees. The term “defined” is used because the plan uses a benefit formula that is defined in the plan document.

A DB plan works a little differently than your typical 401(k) plan. With a 401(k) plan the IRS limits the amount that you can put in up front.

But a DB plan allows for much larger contributions. This is because the plans are looking to provide a specific benefit at retirement. As such, you can make larger contributions today to reach your retirement goal down the road.

You can think of it like a turbo charged 401(k) plan. Annual retirement contributions are often greater than $100,000 and we have many clients who contribute over $300,000 annually. The plans are more complex to administer but are great for high income business owners. How does a defined benefit plan work? We’ll discuss in the next section.

How do the plans work?

The actuary calculates the participant benefits using a formula that considers various factors, including the length of employment and salary history. Typically, employees must work for a certain period before they become eligible to participate in the plan. Additionally, there may be a waiting period after any employment changes.

The company is responsible for handling the plan’s investments and payout risks. It often hires a financial advisor and plan administrator (“TPA”) to oversee the plan. Unlike a 401(k) plan, participants typically can only withdraw funds at retirement. They receive their benefits as a fixed monthly payment or, in some situations, as a lump sum at an age specified by the plan requirements.

Also referred to as DB pension plans, a DB plan specifies the formula for calculating retirement benefits in advance. Unlike 401(k) accounts where the payout depends on investment returns, DB have a predetermined payout formula.

The company is responsible for overseeing investment decisions and managing investments, which means it takes on all the associated risks. Poor investment returns or errors in assumptions could lead to a funding shortfall. In which case companies are legally obligated to cover the deficit with a cash contribution.

Who are the best candidates?

A defined benefit plan provides a specified amount of retirement income to the plan participant, typically based on a formula that considers the participant’s years of service and earnings history.

Defined benefit plans are generally considered best for individuals who:

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1. Are looking for a predictable and stable source of retirement income: Unlike defined contribution plans, such as 401(k) plans, where the retirement income is based on the performance of the investments, the retirement income from a defined benefit plan is guaranteed and predictable.
2. Have a long-term employment relationship: Defined benefit plans are often associated with traditional, long-term employment relationships and are most commonly offered by government entities and large corporations. A defined benefit plan could be a good option if you plan to stay with your employer for a long time.
3. Are risk-averse: Defined benefit plans are generally considered to be less risky than defined contribution plans because the investment risk is borne by the plan sponsor, not the plan participant. This can be especially attractive for risk-averse individuals with a low tolerance for investment risk.
4. Have a high income: Because DB pension plans typically provide a guaranteed retirement income based on a formula that considers the participant’s years of service and earnings history, they can be especially beneficial for individuals with a high income.
5. Are close to retirement age: You can structure defined benefit plans to provide a higher retirement benefit the closer the participant is to retirement age. If you are close to retirement age, a defined benefit plan may provide a higher retirement income than a defined contribution plan.

What are the pros and cons?

DB plans are what is called a “qualified” plan. This basically means they qualify for a tax deduction or tax deferral. When you contribute to the plan you get an immediate tax deduction but are subject to taxation when you take the funds out at retirement. Let’s point out a few other benefits:

• Plans are not subject to the $57,000 contribution limits that come with defined contribution plans (like a 401k).
• They work for all types of entities. This includes sole proprietors, S-corps, C-corps and partnerships.
• They can be combined with other retirement plans like a 401k, profit sharing plan or even a traditional IRA.
• Solo plans can utilize a a Mega Backdoor Roth to supercharge contributions.
• Contributions are tax deductible.

But there are a few other things that should be considered before you set up a plan:

• The plans are actually “permanent.” This really means that you have to have them open for at least several years. But you are allowed to terminate the plan for reasonable cause.
• Contributions are typically not elective like 401ks or other defined contribution plans.
• An actuary reviews and certifies the plan every year. This is to make sure the funding is able to pay future retirement payments.
• They are more costly to set up and administer. Typical plans will run at least $2,000 to annually administer.
• The plans often have restrictions on any lump sum payment.

Defined benefit plan rules

Defined benefit plans can be set up as owner-only plans. In fact, probably over half of our plans are what you would call “solo” plans. Many clients also do a Mega Backdoor Roth.

How do the plans work? Generally, a defined benefit plan attempts to specify benefit levels for employees. The actuary determines contributions based on plan assumptions. The employer assumes the investment risk used by the employee benefit trust that administers the plan’s assets.

If the investment returns cause the plan assets to fall below the amount actuarially necessary to pay the defined benefits, then the employer must make additional contributions. Thus, defined benefit plans are subject to the minimum funding requirements under ERISA, whereas the defined benefit plan rules have little meaning for defined contribution plans.

DB pension plan rules provide for the payment of definitely determinable benefits to the employees over the years after retirement. In short, it guarantees a monthly income for a participant at retirement age.

Benefits are typically based on:

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• Years of employment;
• Years of participation in the plan; and
• Annual compensation.

Plan design is a process by which the company ensures that the pension plan will meet the business’ goals and objectives for retirement savings, employee retention and tax efficiency.

DB pension plan rules

For example, if a company has key employees (i.e., owners) that are older than the majority of the employees, a defined benefit plan may make the most sense. Employees can accumulate a much larger benefit over a shorter period of time than could be accomplished in a defined contribution plan.

A defined contribution plan is limited in the amount of contribution a plan sponsor can allocate to each employee. Due to this contribution limitation and the age of the employees, there may not be sufficient time to accumulate the desired retirement benefit using a defined contribution plan.

How important is plan design?

In plan design, the type of formula considered should be based on how the plan sponsor wishes to benefit certain groups of individuals. If it is important to the plan sponsor to favor employees with long service, then a unit benefit plan may be best. If the plan sponsor wishes to favor employees based on compensation level, then the formula should use a percentage of pay instead of a flat dollar amount. An administrator can provide a defined benefit plan illustration to show multiple contribution levels.

The plan sponsor should also consider the amount of money it can afford to contribute to a plan each year. A high dollar amount or percentage of pay formula may require a greater contribution than the plan sponsor can afford. Thus, you should design the plan with a budget in mind. The IRS requires that a plan be “permanent” and not just a temporary tax structure.

Although plans can be terminated for valid business necessity, the company should plan on maintaining a plan for many years. This is because the IRS expects plans to satisfy a “permanency” standard. This standard usually includes a minimum number of years that the plan is in effect.

What if I have employees?

How does a DB pension plan work with employees? There is no doubt that these plans work best for solo business owners or professionals. You must make a contribution for eligible employees. But there are ways to limit your exposure.

As a guide, the employer can exclude part time employees and certain other employees but will need to make a contribution of approximately 5 to 7% for remaining employees in order to pass the defined benefit plan rules.

Employee contributions are usually not that significant at the end of the day. Our goal is to get 85% to 90% of the contributions for the business owner. This is not always possible if the owner has substantial high income and older employees. But that is at least the goal.

Plan illustration

IRS assumes supervisory activities of DB pension plans. The defined benefit plan rules and regulations have helped avoid abuse of privileges granted to them.

One very important rule is “non-discrimination.” It verifies that a plan does not favor highly compensated employees. The regulations have favored DB plans and have encouraged employers and employees to increase their retirement savings. However, the IRS and the Department of Labor have strict compliance standards you will see on the illustration.

The employer can exclude part-time employees and certain other employees but must contribute approximately 5 to 7% for the remaining employees to pass the rules. Employees receive annual contributions from the employer.

Investment choices

Investment in defined benefit plans works by ensuring a predetermined, fixed retirement benefit for participants, often based on factors such as salary history and years of service. Unlike defined contribution plans, where the retirement benefit depends on the individual’s account balance and investment performance, defined benefit plans promise a specific payout upon retirement.

The company contributes to a pooled investment account. Because the employer bears the investment risk, they must meet required funding levels to guarantee that the plan remains financially viable and secure for all participants.

To achieve the required funding for these promised payouts, financial advisors invest in a mix of assets, typically including stocks, bonds, real estate, and other income-generating investments. The financial advisor chooses the asset allocation strategy to balance potential growth with the security needed to meet long-term liabilities.

For example, the advisor will often use bonds for their steady income and lower volatility. This helps maintain consistent funding. Stocks may be included for their growth potential. Over time, the plan’s portfolio may adjust based on factors such as market conditions, changing participant demographics, and interest rates, all of which impact the plan’s funding status and ability to meet payout commitments.

Defined benefit plans are heavily regulated to ensure solvency. As such, companies are often required to maintain a minimum funding level by the IRS and ERISA. If the fund experiences underperformance, the employer must make additional contributions to cover the shortfall, preserving the stability of promised benefits. This makes defined benefit plans attractive for employees who prefer a predictable, lifelong income stream in retirement, as they don’t bear the investment risk or have to manage the funds.

However, for employers, these plans can be costly to maintain and require regular monitoring and strategic adjustments to their investment approach to manage long-term liabilities effectively.

Fiduciaries must monitor the pension funds and remove any funds that don’t perform well. Some investment providers (such as insurance companies, mutual fund companies, and banks) help fiduciaries by giving them performance, expense, benchmarks, and other information and removing underperforming funds from their investment packages.

Other advisors, such as investment consultants, can help the fiduciaries evaluate the participants’ investments.

How to establish a DB plan

Final thoughts

What is a DB Plan? As you can see, DB plans are one of the best tax planning and retirement structuring tools in the market. No other plans allow self-employed people to make such substantial tax deferred contributions.

But you don’t have to take my word for it. Just submit a request and we will run you a free illustration so you can see for yourself. You may have just uncovered an excellent retirement tool!