Employer-sponsored retirement plans that provide fixed annual payments when an employee retires are known as defined benefit plans. These plans give retired employees a predictable source of retirement income while also providing the employer with significant tax-savings.
Like other plans, defined benefit plans provide tax benefits to both businesses and employees who participate in these plans. For example, contributions to these plans are fully deductible by the employer. You won’t owe tax on those payments until you start getting distributions from the plan, in most cases (usually during retirement).
However, under the Employee Retirement Income Security Act of 1974 (ERISA) and the Internal Revenue Code, all qualified plans, including defined benefit plans, must adhere to a complex set of restrictions.
What Is a Defined Benefit Plan?
When you retire, a defined benefit plan guarantees you a set amount of money. The amount you receive is usually determined by factors such as your income, age, and number of years you’ve worked for the organization.
Pension actuaries compute the future benefits expected to be paid from the plan each year, and then decide how much needs to be contributed to the plan to cover the expected benefit payout.
In most cases, employers are the only ones who contribute to the plan. Defined benefit plans, on the other hand, may compel employees to contribute to the plan.
You may have to work for a certain number of years to get eligible for any retirement plan, “Vesting” is the term used to describe this process. If you quit your employment before fully vesting in a defined benefit plan, you will not be eligible for the plan’s full retirement benefits.
What Businesses Are Good Candidates For A Defined Benefit Plan
In a typical defined benefit plan structure for a small business it is the employer that makes the contribution to the plan. The employees do not contribute out of their own paychecks to the plan. The contributions are allocated to all eligible employees but not evenly. Employees that are older and/or earning a higher salary receive a much higher share than employees who are younger or earning a much lower salary.
The ideal candidate for a defined benefit plan is a highly-profitable business where the owner is the main generator of revenue and that has a very limited support staff. In this scenario a very high percentage of the employer contribution is allocated to the owner. The other staff still get a contribution they wouldn’t otherwise have. The business can take a huge tax deduction by legally sheltering income from current taxation.
Most Common Payment Options
Many defined benefit plans provide you the option of choosing how your benefits are paid. These are a few most common payment options:
Single Life Annuity: A single life annuity pays you a fixed monthly income until you die. When you die, your survivors receive no further payments.
Qualified Joint And Survivor Annuity: A qualified joint and survivor annuity pays you a fixed monthly benefit until you die. After you die, your surviving spouse receives benefits (equivalent to at least 50% of your benefit) until his or her death.
Lump-Sum Payment: You will receive a lump sum payment for the whole value of your plan. No further payments will be made to you or your survivors other than the lump-sum.
It’s vital to pick the proper payment option because it can affect the amount of benefit you receive in the end. You should carefully analyze all of your options and compare the benefit payout amounts for each. It is better to talk to a financial and tax adviser about the best plans.
Advantages Of Defined Benefit Plans
Defined benefit plans can be a significant source of income in retirement. When paired with Social Security, they’re usually designed to replace a set percentage (e.g., 70%) of your pre-retirement income. Benefits are not contingent on the performance of underlying investments, so you know how much money you’ll have when you retire.
The federal government insures most benefits up to a specific yearly level through the Pension Benefit Guaranty Corporation (PBGC). A defined benefit plan should not be confused with a defined contribution plan (e.g., 401(k) plan, profit-sharing plan), which is another type of qualified retirement plan.
A defined benefit plan, as the name suggests, focuses on the final rewards given out. Your company agrees to pay you a particular amount in retirement and is responsible for ensuring that the plan has enough assets to pay you this amount ultimately, even if the plan’s investments perform poorly.
A Few Things You Should Consider While Investing in a Defined Benefit Plan
- Read the plan’s summary description. It contains critical information such as vesting criteria and payment alternatives, as well as specifics regarding your company’s pension plan. If there’s anything you don’t understand, contact your plan administrator.
- Examine your account details to ensure that you are aware of the benefits to which you are entitled. Check your Social Security number, birth date, and the compensation used to calculate your benefits on a regular basis, as these are major sources of inaccuracy.
- Any changes in your life that could influence your benefits should be reported to your plan administrator (e.g., marriage, divorce, death of spouse).
- Keep a record of your pension information for each employer where you’ve worked. Ensure that you have all the plan documents such as statements that show the exact amount of benefits you’re entitled to .
- Keep an eye out for any changes in your plan details. Employers have the right to amend or even terminate pension programmes, but you should be notified in advance. Make sure you read all the plan notices you receive.
- Examine the implications of a job change on your pension. Consider sticking with one company until you’re fully vested. Keep in mind that the longer you work for one company, the more money you’ll get when you retire.
Your pension income, combined with Social Security, personal savings, and investment income, can help you achieve your retirement ideal of living comfortably. Begin by determining how much money you may expect from your defined benefit plan when you retire.
Every year, your company will provide you with this information. However, read the small print. Many projections presume you’ll retire at 65 with a single life annuity. If you retire early or receive a combined and survivor annuity, your monthly payout could be significantly reduced. Finally, keep in mind that most defined benefit plans don’t include cost-of-living adjustments, so benefits that look great now could be worth a lot less later on when inflation kicks in.