A defined-benefit retirement plan is a pension plan under which a participant receives a fixed benefit in retirement based upon compensation, age and years of service with a particular employer.
Under a defined benefit plan, it is the benefit that is "defined" as opposed to the contribution. The benefit is guaranteed by the Pension Benefit Guaranty Corporation (PBGC), a federal government agency. There are several variations of the defined benefit plan:
- Cash balance
- 412(i) plan
- Traditional pension plan
Elements of a defined-benefit plan:
- Provides the highest tax-deferred retirement savings for older, highly compensated employees.
- Complex to design.
- A formula determines the level of benefit a participant will receive upon retirement.
- Types of formulas:
- Flat amount formula -Provides a stated dollar amount to each plan participant regardless of compensation level. May require a minimum number of years of service.
- Flat percentage formula - Provides a benefit that is a percentage of the employee's average earnings, either over a career, over the final few years of a career or, possibly, or over the most highly compensated years.
- Unit credit formula - A more complex formula that gives a credit for each year of service that is multiplied by a factor based upon compensation. For instance, a unit credit formula may provide a benefit that 1.2% for each year of service multiplied by the employee's average salary. Two variations of this formula:
- Career average - Formula uses the employee's average earnings from entire career with the employer.
- Final average - Formula uses an average of compensation over the last three or five years of a career with the employer. Usually provides for a higher benefit as most workers are in their peak earning years just before retiring.
- Cash balance plan- A qualified defined benefit plan in which an employer contributes to hypothetical individual accounts for each participant. The contribution and a minimum rate of return are guaranteed for each participant's account.
- Favors younger employers who have more time to accumulate savings.
- Retirement benefits may not accumulate sufficiently for employees who are older when they enter the plan.
- Employer guarantee removes investment risk for employees. Participants make no investment decisions.
- Benefits are guaranteed by the PBGC.
- No actual accounts for individuals; all funds are pooled.
- 412(i) plan - A defined-benefit pension plan funded solely by guaranteed annuities or a combination of annuities and life insurance.
- Suited to small business owners who find it difficult to invest in their company, while also trying to save for retirement.
- Unique in that it provides fully guaranteed retirement benefits, it must be funded by an insurance company and it provides the largest tax-deduction possible due to the large premiums paid each year.
- May not be ideal for all small business owners. This plan would tend to benefit small businesses that are established and quite profitable.
Financial AdvisorDefined benefit plans offer advantages to both employers and employees. Employers must understand the federal tax rules when establishing these plans.
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