Defined benefit pension plans are qualified retirement plans that provide fixed and pre-established benefits to plan participants when they retire. The plans are popular with employees, who enjoy the security of fixed benefits when they retire, and employers, who can make greater contributions to employees and receive greater deductions than in a defined contribution plan. Defined benefit plans can be complex, so employers should understand the rules mandated by the Internal Revenue Service (IRS) and the federal tax code.
Explaining Defined Benefit Pension Plans
A defined benefit pension plan requires an employer to make annual contributions to an employee's retirement account. The plan administrators hire an actuary to calculate the future benefits that the plan must pay the employee and the amount that the employer must contribute to provide those benefits. The future benefits generally correspond to how long an employee has worked for the company, and the employee's salary and age. Generally, only the employer contributes to the plan, but some plans may require an employee contribution as well.
To receive the benefits from the plan, the employee usually must remain with the company for a certain number of years. This required period of employment is known as the vesting period. Employees who leave a company before the end of the vesting period may receive only a portion of the benefits. Once the employee reaches the retirement age, which is defined in the plan, he or she usually receives a life annuity. Generally, the account holder receives a payment every month until he or she dies.
Examples of Defined Benefit Pension Plans
As an example, one type of defined benefit plan might pay a monthly income equal to 25% of the average monthly compensation that the employee earned during his or her tenure with the company. An employee who made an average of $60,000 annually would receive $15,000 in annual benefits, or $1,250 every month, beginning at the age of retirement defined by the plan and ending when the participant dies.
Another type of plan may calculate the benefits based on the employee's service with the company. An employee, for example, may receive $100 a month for each year of service with the company. An employee who worked for 25 years would receive $2,500 a month at his or her retirement age.
Variations on Benefit Payments
Each plan has its own rules on how employees receive benefits. For example, in a straight life annuity, the employee receives fixed monthly benefits beginning at retirement and ending when the employee dies. The survivors receive no further payments. In a qualified joint and survivor annuity, the employee receives fixed monthly payments until he or she dies. However, when the employee dies, the surviving spouse continues to receive benefits equal to at least 50% of the employee's benefits until the spouse dies. Some plans offer a lump-sum payment, where the employee receives the entire value of the plan at the time of retirement and no further payments are made to the employee or survivors.
Comparison to Defined Contribution Plan
In a defined contribution plan, the employee funds the plan with his or her own money and assumes the risks of investing. Defined benefit plans, on the other hand, don't depend on investment returns. The employee knows how much to expect at retirement. The federal government does not insure defined contribution plans, according to the Pension Benefit Guaranty Corporation (PBGC).
Federal Tax Requirements
The IRS lists the rules and requirements for employers to establish defined benefit plans. A company of any size can establish a plan, but the company must annually file Form 5500 with a Schedule B. Furthermore, the company must hire an enrolled actuary to determine the plan's funding levels and sign Schedule B. In addition, companies cannot retroactively decrease benefits. Companies that do not make the minimum contributions to their plans, or that make excess contributions, must pay federal excise taxes. The IRS also notes that defined benefit plans generally may not make in-service distributions to participants before age 62, but the plans may loan money to participants.