What Is a DB(k) Plan?
A 401(k) plan is a tax-advantaged, defined-contribution retirement account offered by many employers to their employees. A defined-benefit plan is an employer-sponsored retirement plan where employee benefits are computed using a formula that considers several factors, such as length of employment and salary history. A traditional pension fund is one type of defined benefit plan.
Similar to a 401(k) plan, funds can be voluntarily contributed to the DB(k) plan, with the employer retaining the option to match the funds up to a certain percentage. Upon retirement, the employer will also pay the employee a small percentage of their salary, which is similar to a traditional pension fund.
- A DB(k) plan is a hybrid of a 401(k) and defined benefit pension plan for employee retirement savings.
- Like a 401(k) plan, the DB(k) requires employees to contribute funds to retirement investments.
- Like a defined benefit pension, there is also a guaranteed retirement income portion of the plan.
Understanding DB(k) Plans
The DB(k) plan was initially designed to provide small businesses especially, defined as businesses with at least two employees but less than 400, with a way to attract employees.
Many investors worry that their entire retirement savings could be wiped out in a down market. Retaining the pension characteristic means that the retiree will still have a source of income, regardless of the performance of the investments within the 401(k) portion of the plan. Because the DB(k) plan combines both a defined benefit component and a 401(k) component, there are some specifications for each category.
The Pension Protection Act of 2006
The DB(k) Plan has the official name of the Eligible Combined Plan and was created by the U.S. Congress as part of the Pension Protection Act of 2006 under Section 414(x) of the Internal Revenue Code.
The Pension Protection Act of 2006 sought to protect retirement accounts and hold accountable those companies that underfunded existing pension accounts. The Act attempted to close some of the loopholes that allowed the companies that paid into the Pension Benefit Guaranty Corporation to cut pension funding. The legislation also made it easier to enroll employees into their 401(k) plan.
The Pension Protection Act of 2006 brought about the most significant changes made to defined benefit plans since the Employee Retirement Income Security Act of 1974 (ERISA).
Defined Benefit Component:
- The employee is required to receive at least 1% of pay for each year of service, but the total amount cannot exceed 20 years.
- Benefits are vested after 30 years of service.
- There must be an auto-enrollment provision with a 4% contribution rate unless the employee elects to reduce this rate or opt out.
- The employer must match 50% of the employee’s 401(k) contributions, up to 4% of compensation, or a 2% maximum match.
- Employees must be fully vested to receive the matching contribution, and vesting occurs after three years of employment.
Criticisms of DB(k) Plans
Although the DB(k) Plan sounds like a good idea, in theory, its practical application has faced some challenges. Since their introduction via The Pension Protection Act of 2006, DB(k) plans have actually been slow to grow. The lack of popularity for DB(k) plans may be due to the strict application requirements by the Internal Revenue Service (IRS) for the plan’s designation.
For instance, in order to set up a DB(k) Plan, an employer is required to file two separate Form 5300s for each component of the plan, which also means paying two fees for each separate component within the account. The accounts are also often too costly for many small business employers to run since they essentially double the amount of work required for one retirement plan, as each plan requires separate administration. As a result, very few companies have signed up and operate a DB(k) Plan.