Setting up a new retirement plan? Before you get started, you better make sure that you understand the difference between a defined benefit plan and a defined contribution plan.
Simply put, a defined benefit plan establishes the benefit that is paid out in the future, while a defined contribution plan establishes the amount that can be contributed to the plan and does not address any future amount. But let’s take a look at the specifics.
Table of contents
- How Does a Defined Benefit Plan Compare to a Defined Contribution Plan?
- Difference Between Defined Benefit Plan and Defined Contribution Plan
- Accumulation Comparison
- Administrative Differences
- Any other differences?
- Understanding the difference between a defined benefit plan and a defined contribution plan
- Final thoughts
How Does a Defined Benefit Plan Compare to a Defined Contribution Plan?
The core of the difference between defined benefit and defined contribution plans lies in who gets affected by the plan’s rate of return. In a defined contribution plan, a participant receives whatever balance is in his account based on the rate of return in the plan.
In a defined benefit plan, the plan sponsor is taking responsibility for any fluctuations in the market. The participant must receive a fixed amount and, if the plan’s investments do not earn a rate of return to guarantee that benefit, then the sponsor must contribute enough to make up the difference.
Because of the nature of the defined benefit plan, the costs are significantly higher for older employees than younger employees. Assuming retirement at age 60, the plan sponsor has 35 years to “fund up” the benefit for a 25-year-old but only 5 years for a 55-year-old. Therefore, a defined benefit plan can offer significant advantages for an older employer with younger employees as illustrated below.
Difference Between Defined Benefit Plan and Defined Contribution Plan
A corporation has two non-key employees and two owners. The non-key employees each earn $30,000 and are ages 25 and 35 on the first day of the plan year. The owners each earn in excess of $200,000 and are ages 55 and 65.
Retirement age is defined as the later of age 60 or five years of plan participation. The contributions under a defined benefit plan as contrasted to a 20% of pay defined contribution plan are illustrated below:
The defined benefit plan offers a higher percentage to the self employed owner, and the dollar amount available for the owner is significantly higher. However, one of the disadvantages of defined benefit plans is the increased costs for older employees. If this corporation had a 45- or 55-year-old employee earning $30,000, the respective costs would be $14,895 and $38,186.
Next we look at the amounts accumulated in five years for the example above. This would be the date that the owners reach normal retirement age under the plan. For the defined contribution plan we assumed a 6% average rate of return over all years.
A defined benefit plan must meet more complex regulatory restrictions and administrative procedures. An actuary is required to certify the annual costs and calculate the annual valuation of benefits for employees. Administrative fees are generally higher due to these factors. But make sure that you get a quote from a defined benefit plan TPA.
Defined benefit plans must pay a premium and report funding levels annually to the Pension Benefit Guaranty Corporation (PBGC). The PBGC is a federal entity that insures benefits in most defined benefit plans. Generally, plans that only cover owners and plans sponsored by professional organizations that employ less than 25 individuals are exempt from PBGC coverage.
The PBGC will pay benefits to participants if the funds are insufficient to do so and the plan sponsor is unable to contribute enough to make up the difference. The PBGC then goes after the plan sponsor to pay back the difference.
Any other differences?
One of the most notable benefits is the contribution limit that comes with a cash balance plan. Having a cash balance plan can allow for a larger contribution amount, allowing people to save more as the approach retirement.
Increased benefit and compensation limits included in the Economic Growth and Tax Relief Reconciliation Act (“EGTRRA”) as well as the downturn in investment markets have refocused attention on defined benefit plans as alternatives to defined contribution plans.
Understanding the difference between a defined benefit plan and a defined contribution plan
- Are contribution amounts limited upfront? Defined contribution plans establish contribution limits up front. What the funds earn subsequently is not relevant.
- Are you looking for a benefit in the future? If you are looking to “lock in” an amount at some point down the road then that is more characteristic of a defined benefit plan.
- Have you considered contribution levels? If you are comfortable with relatively low contributions like $10,000 to $30,000 then stick with a defined contribution plan. If your goal is $100,000 plus in contributions you will need to consider a defined benefit plan.
- What about plan costs? Because of the complexity and need for an actuary, defined benefit plans will cost substantially more. But the large contributions may justify the higher cost.
- How long do you plan on having the plan? Remember that defined benefit plans are meant to be permanent plans. But defined contribution plans are generally elective, so you can choose if you will contribute from year to year.
The defined benefit plan design can offer larger accumulations at retirement for some small business owners with lower costs for younger, non-key employees. However, there can be negative consequences that must be explored before such a plan is adopted.
Defined benefit plans can be a valuable tool for retirement planning. There are additional pension rules and administrative burdens that accompany these plans. A plan sponsor who is educated as to the potential pitfalls and secure in continuing the plan can accumulate substantial amounts within these plans by retirement age.