ComplianceLegalFinanceTax & AccountingFebruary 10, 2021

Understanding defined benefit and defined contribution plans

Retirement plans fall into two basic broad categories: defined benefit plans or defined contribution plans. The difference between the two is substantial and it's important to understand the characteristics of both categories in order to make the right retirement plan benefit choices.While the types of retirement plans available to employers wishing to offer one as an employee benefit are numerous, the two major categories of retirement plans are defined benefit plans and defined contribution plans. Each category has its own subcategory of plans and unique features. Hybrid plans are also available.

Defined benefit retirement plans

A defined benefit plan is one set up to provide a predetermined retirement benefit to employees or their beneficiaries, either in the form of a certain dollar amount or a specific percentage of compensation.

Employer contributions to a defined benefit plan are very complex to determine and require the work of an actuary. The assets of the plan are held in a pool, rather than individual accounts for each employee, and as a result, the employees have no voice in investment decisions. Once established, the employer must continue to fund the plan, even if the company has no profits in a given year. Since the employer makes a specific promise to pay a certain sum in the future, it is the employer who assumes the risk of fluctuations in the value of the investment pool.

Types of defined benefit plans. There are three basic types of defined benefit plans:

  • Flat benefit plan. All participants receive a flat dollar amount as long as a predetermined minimum years requirement has been met.
  • Unit benefit plan. Provides a benefit that is either a percentage of compensation or a fixed dollar amount multiplied by the number of qualifying years of service.
  • Variable benefit plan. Benefits are based on allocating units, rather than dollars, to the contributions to the plan. At retirement, the value of the units allocated to the retiring employee would be the proportionate value of all units in the fund.

The maximum annual contribution you can make to a defined benefit plan is one that would be projected to yield a benefit equal to the lesser of $210,000 for 2014 ($205,000 for 2013; this amount may be adjusted annually for inflation), or 100 percent of the participant's average compensation for the three highest consecutive years.

Very few defined benefit plans provide for the benefits to be adjusted each year to reflect the effects of inflation (called the Cost of Living Adjustment, or COLA), so over the years of your retirement, the value or purchasing power of your benefits may shrink considerably.

The Pension Benefit Guarantee Corporation (PBGC). With a defined benefit plan the employer is legally required to make sure there is enough money in the plan to pay the guaranteed benefits. If the company fails to meet its obligation, the federal government steps in. Defined benefit plans are the only type of pension insured by the PBGC. The insurance works similarly to the federal deposit insurance that backs up your bank accounts. If your plan is covered and the sponsoring company goes bust, PBGC will take over benefit payments up to a maximum amount. The insurance protection helps make your pension more secure, but it is not a full guarantee that you will get what you expected.

Defined contribution plans include popular profit-sharing plans

The way that a defined contribution plan works is that either an individual alone, or an employee and the employer make contributions into the plan, usually based on a percentage of the employee's annual earnings. Each participant has an individual, separate account. There is no way to determine in advance what the final payout at retirement will be. Benefits depend on how much was contributed in the employee's name and how well the pension fund investments performed. So, the risk of fluctuations in investment return is shifted to the employees.

The government sets a limit on how much can be contributed in an individual's name each year no matter how many different plans he or she participates in. The total amount that can be contributed in one employee's name for 2014 is the lesser of $52,000 ($51,000 for 2013) or 100 percent of the employee's annual earnings. The contributions are allocated to separate accounts for each participant based on a definite, predetermined formula. Forfeitures can be reallocated to remaining participants.

The defined contribution plan category contains a broad range of plans including profit-sharing plans, money purchase plans, 401(k) plans, employee stock ownership (ESOP) plans and two types of plans especially popular with small businesses: SIMPLE plans and SEPs (simplified employee pensions).

Profit-sharing plans

Initially developed to encourage hard work and loyalty, profit-sharing plans encourage companies to set aside money in the employees' names when the company shows a profit. The employer may decide not to contribute in any given year, if it so desires.

Profit-sharing plans allow employers to make contributions to an account that earns investment income and is sheltered from taxation until the money is actually distributed. The employer's contributions are usually based on a percentage of the profits that the business makes, but contributions can be made even if the business makes no profit for the year. Often, profit-sharing plans involve using a 401(k) plan, in which the employee can make voluntary contributions out of his or her pre-tax salary.

Profit-sharing plans involve the risk that the benefits may be inadequate at retirement. Their great advantage from the employer's point of view is that there is no commitment requiring contributions to the plan in lean years.

Who benefits most from profit-sharing plans? Younger employees, short-service employees, employees in lower-pay brackets, and employees who quit after medium lengths of service are those who will benefit most from profit-sharing plans.

Profit-sharing plans cannot meaningfully take into account an employee's (or owner's) years of service for purposes of computing benefits, as a target benefit plan could. The Internal Revenue Service insists that a profit-sharing plan is discriminatory if contributions each year are not allocated to employees on the basis of a uniform relationship to compensation. For this reason, it is virtually impossible to provide greater contributions (and, therefore, greater eventual benefits) for long-service employees in a profit-sharing plan, except to the extent that long-service employees are paid a higher salary.

401(k) plans

Many qualified defined contribution plans permit participating employees to make contributions to a plan on a before-tax basis. These plans are called cash or deferred arrangements (CODAs, or more popularly, 401(k) plans, named after the Internal Revenue Code provision dealing with CODAs). They enable participants to save for retirement on a before-tax basis. The employees authorize their employer to reduce their salary and contribute the salary reduction on their behalf to a qualified retirement plan. In addition to these employee elective deferrals, an employer can make supplemental contributions on behalf of employees. These employer contributions can be subject to a vesting schedule, but the employees' contributions must be nonforfeitable.

The employee's elective deferral to all 401(k) plans is limited to $17,500 for 2013 and 2014 (this amount may be adjusted annually for inflation). Those who are age 50 and over in 2013 or 2014, can contribute an additional $5,500 for the year. The employer contribution is also subject to separate, complex limitations.

Generally, withdrawals from 401(k) plans are not permitted before age 591/2 unless the employee retires, dies, becomes disabled, changes jobs, is a reservist called or ordered to active military duty for more than 179 days, or suffers a financial hardship as defined by Internal Revenue Service regulations.

Employee stock ownership plans (ESOPs)

An ESOP is a stock bonus plan or a combination stock bonus plan and money purchase plan that is designed to invest primarily in qualifying employer securities and to use borrowed funds to do so. An ESOP is funded by employer contributions of stock in the corporation or allows you to buy shares of stock as a plan investment option.

ESOPs must comply with all the requirements imposed on other types of defined-contributions plans and cannot be integrated with Social Security.

Money purchase plans

In money purchase plans, the employer is obligated to contribute even if the company didn't make a profit. The contributions are determined by a specific percentage of each employee's compensation and must be made annually.

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