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.

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.

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.