Types of Retirement Plans - Defined benefit
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.