Increased benefit and compensation limits included in the Economic Growth and Tax Relief Reconciliation Act (“EGTRRA”) as well as the downturn in investment markets have refocused attention on defined benefit plans as alternatives to defined contribution plans. The defined benefit plan design can offer larger accumulations at retirement for some small business owners with lower costs for younger, non-key employees. However, there can be negative consequences that must be explored before such a plan is adopted.
What is a Defined Benefit Plan?
A defined benefit plan is a retirement program that promises a specific benefit to participants at retirement age. The benefit is normally defined as a monthly pension equal to a percent of pay (flat benefit plan) or a percent of pay times years of service (unit benefit plan). The compensation used in calculating the monthly benefit is usually based on the highest three or five year average.
In a defined benefit plan, the plan sponsor contributes whatever is necessary to reach the promised payout at retirement age. An actuary converts the monthly annuity payable at retirement to a lump sum. The actuary then determines each year what amount is required as a contribution based on the current value of plan assets and the date those benefits are due to each participant.
The contribution can vary depending on investment returns. Low investment returns cause higher required contributions, and high investment returns lower the contribution requirement.
How Does a Defined Benefit Plan Compare to a Defined Contribution Plan?
The core of the difference between defined benefit and defined contribution plans lies in who gets affected by the plan’s rate of return. In a defined contribution plan, a participant receives whatever balance is in his account based on the rate of return in the plan. In a defined benefit plan, the plan sponsor is taking responsibility for any fluctuations in the market. The participant must receive a fixed amount and, if the plan’s investments do not earn a rate of return to guarantee that benefit, then the sponsor must contribute enough to make up the difference.
Because of the nature of the defined benefit plan, the costs are significantly higher for older employees than younger employees. Assuming retirement at age 60, the plan sponsor has 35 years to “fund up” the benefit for a 25-year-old but only 5 years for a 55-year-old. Therefore, a defined benefit plan can offer significant advantages for an older employer with younger employees as illustrated below.
Contribution Comparison
A corporation has two non-key employees and two owners. The non-key employees each earn $30,000 and are ages 25 and 35 on the first day of the plan year. The owners each earn in excess of $200,000 and are ages 55 and 65. Retirement age is defined as the later of age 60 or five years of plan participation. The contributions under a defined benefit plan as contrasted to a 20% of pay defined contribution plan are illustrated below:
The defined benefit plan offers a higher percentage to the owners, and the dollar amount available for the owners is significantly higher. However, one of the disadvantages of defined benefit plans is the increased costs for older employees. If this corporation had a 45- or 55-year-old employee earning $30,000, the respective costs would be $14,895 and $38,186.
| Cost Comparison | ||
| Employee | Defined Benefit |
Defined Contribution |
| Age 25 | $2,921 | $6,000 |
| Age 35 | $6,153 | $6,000 |
| Owner 55 | $145,151 | $40,000 |
| Owner 65 | $167,838 | $40,000 |
| Total | $322,063 | $92,000 |
| % to owners | 97.2% | 87.0% |
Accumulation Comparison
Next we look at the amounts accumulated in five years for the example above. This would be the date that the owners reach normal retirement age under the plan. For the defined contribution plan we assumed a 6% average rate of return over all years.
| Accumulation Comparison | ||
| Employee | Defined Benefit |
Defined Contribution |
| Age 25 | $10,953 | $33,823 |
| Age 35 | $26,143 | $33,823 |
| Owner 55 | $826,436 | $225,484 |
| Owner 65 | $955,611 | $225,484 |
Administrative Differences
A defined benefit plan must meet more complex regulatory restrictions and administrative procedures. An actuary is required to certify the annual costs and calculate the annual valuation of benefits for employees. Administrative fees are generally higher due to these factors.
Defined benefit plans must pay a premium and report funding levels annually to the Pension Benefit Guaranty Corporation (PBGC). The PBGC is a federal entity that insures benefits in most defined benefit plans. Generally, plans that only cover owners and plans sponsored by professional organizations that employ less than 25 individuals are exempt from PBGC coverage.
The PBGC will pay benefits to participants if the funds are insufficient to do so and the plan sponsor is unable to contribute enough to make up the difference. The PBGC then goes after the plan sponsor to pay back the difference.
Benefits Before Retirement Age
In a defined contribution plan, the benefit upon termination of employment is the vested percent of the participant’s account balance. The vested percent increases with service, generally reaching 100% by the seventh year.
In a defined benefit plan, the account balance is replaced by the concept of an accrued benefit. A participant accrues (or earns) a portion of his projected benefit at retirement each year that he is in the plan. For example, a participant who will be in the plan for ten years at retirement might accrue one-tenth of his benefit for each year of plan participation. Assuming a projected pension of $100 per month, this participant would have an accrued benefit of $10 per month after the first year, $20 per month after the second year and so forth. Vesting is then applied to the accrued benefit.
When a participant terminates, his benefit is defined as a certain amount payable at retirement age as an annuity. An actuary determines the present lump sum value of that annuity. If the current value is less than $5,000, the participant may generally take the distribution in cash (either as a rollover or a taxable distribution). If the value is more than $5,000, the default form of distribution is a joint and survivor annuity.
A joint and survivor annuity pays a monthly amount during the life of the participant and a reduced amount (usually 50%) upon the death of the participant for the remaining life of the spouse. Both the spouse and the participant must consent in writing to waive this form of benefit if the participant wants to take a lump sum or other form of annuity.
Defined benefit plans can offer loans to participants. The maximum available loan is based on the lump sum value of the vested accrued benefits of the participants (as opposed to the account balances). In-service withdrawals before retirement age are generally not available and hardship withdrawals are not allowed.
Advantages and Disadvantages of Defined Benefit Plans
The primary advantage of a defined benefit plan is the ability to accumulate large amounts for older key employees. The plan sponsor can make deductible contributions to ensure that the benefit is in place no matter what the market conditions are. Therein also lies the primary disadvantage of such plans: low market returns can cause an increase in contribution requirements at a time when the employer may not be able to meet those requirements.
Employee perception of this type of plan can work for or against the employer. If the defined benefit plan is presented as a way to protect employees from market fluctuations and guarantee benefits, the plan may be well accepted. The current down market would make the plan even more desirable to them. On the other hand, as benefits are generally illustrated as monthly pensions payable at a future retirement date, employees may have difficulty putting a current value on the benefit accruing to them.
Under current regulations, a lump sum payout to a terminated participant must be calculated using two methods. The first calculation uses and, in a well funded plan, would come close to the funds that have been put away for the participant over time with interest. However, the benefit must then be recalculated using IRS mandated rates which are based on 30-year Treasury bills. This can result in a payout to a terminated participant that is as much as 250% of the amount funded. These inflated payouts then lower the overall funding of the plan and cause higher contributions.
These regulations, combined with current low Treasury bill rates, have caused many plans to become significantly underfunded. There are several legislative changes being considered to minimize the impact of this problem, but a plan currently in existence can find itself paying out amounts far greater than anticipated to terminated participants.
Who Should Consider a Defined Benefit Plan?
The ideal candidate for a defined benefit plan is a business owner who is age 40 or older. A plan sponsor with no other employees or only young employees will have the lowest non-owner costs. The plan sponsor must be aware that the contributions are mandatory and feel that future cash flow will support the continuation of the plan. The risks of inflated costs due to market fluctuations and/or the hire of older employees must be anticipated.
Add-On 401(k)
Plan sponsors who maintain both a defined benefit and a defined contribution plan have a maximum deduction limit of the greater of 25% of eligible payroll or the defined benefit required contribution. Under EGTRRA, employee contributions towards a 401(k) plan do not count towards this limit. The result of this change is that employers with defined benefit plans can add on a 401(k) plan that allows for participant deferrals only (no employer contributions).
For the plan sponsor without non-highly compensated employees, this would mean an additional contribution in 2003 of $12,000 if under age 50 or $14,000 if age 50 or older. If there are common-law employees, the deferral by highly compensated employees would be limited based on the average deferral by those employees.
Conclusion
Defined benefit plans can be a valuable tool for retirement planning. There are additional risks and administrative burdens that accompany these plans. A plan sponsor who is educated as to the potential pitfalls and secure in continuing the plan can accumulate substantial amounts within these plans by retirement age.
This newsletter is intended to provide general information on matters of interest in the area of qualified retirement plans and is distributed with the understanding that the publisher and distributor are not rendering legal, tax or other professional advice. Readers should not act or rely on any information in this newsletter without first seeking the advice of an independent tax advisor such as an attorney or CPA.
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Spring will arrive soon, promising new growth and a fresh beginning. It could also be the perfect time to do some spring cleaning for your plan. Let’s look at some areas that you might consider reviewing to ensure your retirement plan is operating efficiently.
Document your processes and procedures to make certain that plan tasks can be handled in case of any absences during an enrollment or pay period. Having a backup in place can prevent errors and delays that could lead to penalties.
Make sure to have a process in place to notify all new enrollments of their eligibility, regardless of whether the plan has automatic enrollment. Depending on the timing for plan entry, including the plan enrollment paperwork with the new hire paperwork could make entry easier for you. Please reach out with any questions regarding when an employee enters the plan.
Deposits of employee deferrals and loan repayments must be submitted to the plan as soon as possible to avoid penalties and corrections. For plans with less than 100 participants, a safe harbor rule allows deposits to be made within seven business days. For larger plans, the expectation is that the money will be deposited more quickly. Depositing these funds on the pay date will avoid the possibility of being late.
Monitoring deferral contribution limits during the calendar year will avoid refunds after year end. Make sure that your payroll is set up to stop deferrals once the limit is reached, including any catch-up contributions for those who have reached age 50.
To keep the plan in compliance, employer contributions must be deposited timely. Due dates are impacted by the type of contributions, required status and tax deductibility. If you have questions on when to deposit your employer contribution or even whether to make an employer contribution, please contact us.
Most plans must be covered by a fidelity bond. The minimum coverage is 10% of plan assets (rounded up to the next $1,000) and the maximum coverage is $500,000. Additional requirements apply to plans with employer securities or non-publicly traded assets. If your fidelity bond is insufficient, now is the time to raise the coverage. Inflation clauses that increase the bond amount as the plan assets increase can ensure that your bond coverage is always adequate. Contact us or your insurance provider if you don’t have a fidelity bond.
Another area to review is communication with participants. Helping your employees understand and trust the plan can increase their contributions. Be sure that your procedures include distributing any plan-related communications—including required participant notices.
Distributions also involve communication, including some of the aforementioned notices. Discussing distribution options with terminated participants, possibly as part of an exit interview, can help to reduce risk of lost participants. We’ll provide instruction on distributions for force-out distributions for small balances, testing corrections and required minimum distributions.
Your plan document is the legal source on how the plan should be administered; operating within its parameters is critical. It’s always worth taking time to review the plan document to ensure that you fully understand and are following its provisions. We’ll cover more details about the plan document later in this newsletter. We’re here to support you in keeping your plan in compliance. Please feel free to reach out with any questions.
Addressing the Challenge of Uncashed Distribution Checks
Uncashed distribution checks present a persistent and often overlooked challenge for retirement plan sponsors. Despite the best efforts of plan administrators, some participants fail to cash their distribution checks, leading to administrative burdens, fiduciary concerns and potential compliance issues. A recent publication by Retirement Management Services (RMS) sheds light on this issue and offers practical guidance for employers seeking to manage and mitigate the risks associated with uncashed checks.
Uncashed checks can arise for various reasons. Participants may have moved without updating their contact information, may not recognize the check as legitimate or may simply forget to deposit it. Regardless of the cause, the responsibility for addressing these uncashed funds ultimately falls on the plan sponsor. This creates a fiduciary obligation to act in the best interest of the participant while ensuring compliance with IRS and Department of Labor (DOL) regulations.
Sponsors are encouraged to maintain up-to-date contact information for all plan participants and to follow up promptly when checks remain uncashed. This may involve sending reminder letters, making phone calls or using certified mail to confirm receipt. In some cases, plan sponsors may also consider using electronic payment methods to reduce the likelihood of checks going uncashed in the first place.
The IRS and DOL have issued guidance on how to handle these situations, including the use of forfeiture accounts and escheatment to state unclaimed property programs. However, these options come with their own set of rules and potential pitfalls. For example, using a forfeiture account may require the plan document to explicitly allow for such treatment. Escheatment laws, which allow the government to assume control of unclaimed property, vary by state. As such, plan sponsors must carefully evaluate their options and consult with legal or compliance experts as needed.
Another important consideration is the documentation of all the efforts made to contact participants and resolve uncashed checks. Maintaining a clear audit trail can help demonstrate fiduciary prudence and protect the plan sponsor in the event of an audit or legal challenge. It is extremely important to have a written policy in place that outlines the steps to be taken when a check remains uncashed beyond a certain period.
By taking a proactive, well-documented and compliant approach, employers can fulfill their fiduciary duties, reduce administrative burdens and ensure that participants receive the benefits they are entitled to.
Source: Retirement Management Services – “Uncashed Distribution Checks” https://www.consultrms.com/Resources/59/Plan-Sponsor-Tips-and-Help/212/Uncashed-Distribution-Checks
Divorce and the Retirement Plan
When a participant in a qualified retirement plan undergoes a divorce, the participant’s account balance may be an asset that is split with the former spouse. As the plan exists for the exclusive benefit of its participants, a court order is required to transfer the participant’s benefits to the ex-spouse. Once approved by the plan administrator, this court order is called a Qualified Domestic Relations Order (QDRO).
The QDRO is a judgment, decree or order that must be issued by a state authority (usually a court). It can be part of the divorce settlement or it may be a separate document. Because of the serious nature of separating the participant’s account balance, the QDRO is more than just an agreement made by both parties — it must also be signed by a judge.
A QDRO will describe how to divide the participant’s account balance between the participant and the ex-spouse, referred to as the alternate payee. In some cases, a set dollar amount will be allocated; in others, a percentage of the account may be designated. In the latter case, the amount assigned to the alternate payee represents the given percentage of the participant’s total vested account balance as of a specified valuation date. This percentage will apply to all sources — such as deferrals, matching or profit sharing — unless specified by the QDRO. Any interest and investment gains/losses that accrue between this valuation date and the date the funds are separated into an account for the alternate payee are often factored into this final calculation. If the participant has outstanding loans, the QDRO will usually indicate how the loans are handled.
Contributions such as deferrals and employer matching made after the valuation date are credited to the participant’s account. Earnings and losses are applied to the account balances. Once the division is complete, the alternate payee’s portion (either dollars or shares) is transferred to an account in the alternate payee’s name.
If the plan allows, the alternate payee may be paid out in a cash or rollover distribution. Not all plan documents allow the alternate payee to receive a distribution before reaching normal retirement age, so it’s important to follow the terms of the plan. In addition, the QDRO cannot violate the provisions of the plan document by requiring a plan to provide an alternate payee or participant with any type or form of benefit not otherwise provided under the plan.
Although the most common situation for a QDRO is a divorce, it can be issued in other situations, such as to a dependent in the case of child support. If the alternate payee is a minor child or legally incompetent, the order can also require payment to the individual with legal responsibility for the alternate payee. If a participant or their attorney provides you with a copy of a divorce decree that references the plan or a QDRO, please contact us immediately, and we will work with you to ensure it meets the requirements of the plan.
Important note for defined benefit plans: For 2025 plan years, PBGC premiums are due one month earlier than usual, specifically on the 15th day of the ninth month after the beginning of the plan year. For calendar year plans, this means the premium is due on September 15, 2025, instead of the usual October 15. This accelerated deadline is due to a provision in the Bipartisan Budget Act of 2015.
Upcoming Compliance Deadlines for Calendar-Year Plans
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