What Is a Target-Benefit Plan?
A target-benefit plan is one that is similar to a defined benefit (DB) plan in which contributions are based on projected retirement benefits. However, unlike a defined benefit plan, the distributions that participants in a target-benefit plan receive at retirement are based on the performance of the investments and are, therefore, not guaranteed.
Note that a target-benefit plan is not the same as a target-date fund, which may be found in defined contribution (DC) retirement accounts like 401(k) plans.
- A target-benefit plan offers contributions that are based on projected retirement benefits.
- It is similar to a defined benefit plan, yet, unlike a defined benefit plan, the retirement distributions paid to participants in a target-benefit plan are not guaranteed.
- The market impacts a target-benefit plan.
- Monthly benefits in target-benefit plans can increase when the market performs well, but decrease following market downturns.
- Target-benefit plans do offer more certainty than defined-contribution plans or 401(k)s.
How a Target-Benefit Plan Works
Target-benefit plans have some attributes of pension plans in that they offer a monthly benefit to the participants or employees. However, a target-benefit plan shifts the risk of whether there are enough funds in the plan to the employees, whereas in a pension plan, the risk is solely on the employer to provide the benefits.
A target-benefit plan provides employees with an estimated target of the monthly benefit, but that target can change over time, depending on the investment returns. In other words, there's no guarantee that the monthly benefit will be there in retirement, nor is there a guarantee of the monthly amount.
The target-benefit plan also bears some similarities to a money purchase plan in that contributions are mandatory. In a money purchase plan, an employee or employer makes annual contributions according to the percentage that the plan requires. For example, a plan that requires a contribution of 5% means the employer contributes 5% of each eligible employee’s pay to their separate account annually. Contributions must be made whether or not the business makes a profit.
A target-benefit plan does share some similarities to a defined-contribution (DC) plan, such as a 401(k). Defined contribution plans are those retirement plans in which employees contribute a fixed amount or a percentage of their paychecks each cycle. An employer will often match an employee’s regular contribution to a DC plan.
In both a DC plan and target-benefit plan, the funds are invested to generate returns so that there will be enough money in retirement for the employees. Also, similar to a 401(k), employees bear the risk that there might not be enough money in the fund. However, the benefit paid to the employee under a target-benefit plan–although not guaranteed–can be more certain than the benefits under a defined contribution plan.
Target-Benefit Plans vs. Defined-Benefit Plans
There are drawbacks to both DB and DC plans. While defined-benefit plans require employers to take larger risks, defined-contribution plans shift the burden of these risks onto the individual workers and retirees. Both have had mixed results.
Defined benefit plans are slightly wider in scope than target-benefit plans. In a defined benefit pension plan, a participant receives a fixed benefit in retirement based upon compensation, age, and years of service with a particular employer. DB plans are guaranteed by the Pension Benefit Guaranty Corporation (PBGC), a federal government agency, while target-benefit plans are not guaranteed.
Cash Balance Plan
There are other variations of defined benefit plans that include a cash balance. In a cash balance plan, an employer credits a participant's account with a set percentage of their yearly compensation plus interest. The company solely bears all ownership of profits and losses in the portfolio.
In a tax-qualified 412(e)(3) plan, designed for small businesses, any amount that the owner contributes to the plan becomes available immediately as a tax deduction to the company. The investments that can fund this type of plan are guaranteed annuities or a combination of annuities and life insurance. 412(e)(3) plans are fully insured plans.
The asset or investment values, as well as the monthly benefits in target-benefit plans, are moving targets. In other words, the benefits are reduced following market downturns and increased when the market performs well. However, target-benefit plans can offer more certainty than defined-contribution plans. Target-benefit plans have arisen in many places outside of the U.S., including the U.K. and the Netherlands.
Does a Target-Benefit Plan Favor Older Employees?
Yes, target-benefit plans generally favor older employees. This is because a characteristic of target-benefit plans is age being one of the determinants of plan contributions.
Is a Money Purchase Pension Plan a Defined Benefit Plan?
Yes, a money purchase pension plan is a defined benefit plan. It is an employer defined-contribution benefit plan, much like a 401(k) plan. The difference between a 401(k) and a money purchase pension plan is that contributions are solely made by an employer, not the employee. The contributions are also fixed on an annual basis.
Can I Have a 401(k) and a Defined Benefit Plan?
Yes, you can set up a defined benefit plan and a solo 401(k) plan, which is known as defined/benefit 401(k), or DB(K). The passage of the Pension Protection Act of 2006 (PPA) allowed for this.