DEFINED BENEFIT PLAN

A defined benefit pension plan promises participants a certain (or “defined”) monthly benefit beginning at normal retirement date.
Retirement benefits are specified by a formula in the plan document typically based on factors including length of service and compensation. The annual benefit that may be paid to a participant under a defined benefit pension plan is limited by the Internal Revenue Code; it is the lesser of (a) $195,000 adjusted for inflation, or (b) 100% of the participant’s average compensation.

The plan is funded using actuarial calculations that factor in variables such as life expectancy, salary increases, rate of investment returns,
cost-of-living adjustments, plan expenses, employee turnover, death, disability, etc. The concept of account balances is absent in a traditional defined benefit pension plan. The participant’s accrued benefit in a defined benefit pension plan is the portion of retirement benefits earned thus far.

ADVANTAGES

• A defined benefit pension plan provides security to the employee, because accrued benefits may not be reduced or eliminate
• Furthermore, the employer bears the risk of investment loss, not the employee
• Older employees can receive much higher benefits in a defined benefit pension plan than in a defined contribution plan
• The maximum employer deduction amount could also be larger in comparison to a defined contribution plan
• A defined benefit pension plan can use a formula that is integrated with Social Security benefits, and provide higher benefits on compensation in excess of the taxable wage base
• A defined benefit pension plan can be structured to encourage early retirement, providing the company an attractive alternative to mandatory layoffs
• Plan benefits may be made subject to a vesting schedule
• Forfeitures reduce the employer’s cost of providing retirement benefits
• With changes in the law stemming from EGTRRA, 2001, an employer can adopt a deferral-only 401(k) plan in addition to its defined benefit pension plan. This allows employees to receive enhanced benefits. The employer can deduct contributions to both plans
• A defined benefit pension plan typically pays benefits in the form of a life annuity, or a qualified joint and survivor annuity. However, plans can also permit optional forms of benefit such as lump-sums and installments
• A defined benefit pension plan may allow for payment of benefits upon reaching normal retirement age, termination of employment, plan termination, disability, or death. Plan loans are also permissible
• A defined benefit pension plan may be adopted by tax-exempt entities, churches and governmental entities, in addition to taxable entities

POSSIBLE DISADVANTAGES

• The employer’s funding obligation to a defined benefit pension plan is not discretionary or optional. Failure to fund the plan
  timely results in the imposition of penalties by the IRS
• Employees struggle to understand the concept of a future benefit being currently funded. There is no neatly wrapped “account balance”
• A defined benefit pension plan must take into consideration additional compliance requirements pertaining to minimum participation
• The annual cost of funding a defined benefit pension plan can be volatile, since it is tied among other things to the performance of trust assets
• The funding of a defined benefit pension plan is required to be certified by an actuary.The only exception is a fully insured plan, sometimes called a 412(i) plan
• A defined benefit pension plan is required to participate in the federal insurance program administered by the Pension Benefit Guaranty Corporation (PBGC) and pay annual premiums. However, owner-only plans, and plans sponsored by certain professional
  service employers with under 26 active participants are exempt
• Participant-directed investment accounts are generally not permitted
• In-service withdrawals are not allowed

ANALYSIS

There exists a common misconception that a plan sponsor is trapped by a defined benefit pension plan once it is established. While it is true that benefits already accrued may not be taken away, the plan sponsor still has a number of options to adjust for shifting financial scenarios and to control costs. It may (a) reduce or eliminate future benefits, (b) close the plan to new participants, (c) freeze the plan, or (d) terminate the plan.

Furthermore, a plan sponsor has a number of choices during the plan’s design stage. A defined benefit pension plan can be established as a cash balance plan, or as part of a floor offset arrangement with a defined contribution plan, or aggregated with a defined contribution plan. A myriad formulas are possible: fixed benefit, flat benefit, unit benefit, and so forth. A number of funding methods are also available such as entry age normal, frozen initial liability, level cost, unit credit, etc. The choice of funding methods has an impact on plan cost.

EXAMPLE

First Year of a Defined Benefit Pension Plan, With Optional 401(k) Plan:

CONCLUSION

The number of private defined benefit pension plans declined from over 100,000 in 1975 to roughly 26,000 in 2004.  PBGC continues to report numerous plan terminations.  In addition, surveys done by consulting companies indicate other actions that close plans to new entrants, change benefit formulas, or otherwise reduce the scope and cost of the plans.  Much of this negative trend can be attributed to inclement economic forces and inimical laws.  The stock market downturn combined with the dramatic fall since 2000 of the 30-year Treasury bond rate used in pension calculations has exacerbated the problem of pension underfunding.

The United States has a voluntary pension system in which no employer is obligated to offer a pension plan.  If defined benefit pension plans are undermined, employers will exit the defined benefit pension system altogether, as many already have.  When IBM’s cash balance plan conversion was ruled as being discriminatory,  IBM, in order to avoid the regulatory and financial uncertainties, responded by closing its cash balance plan to new employees, and instead offering them a 401(k) plan funded from their own paychecks with company matching contributions.  Unless the legislative roadblocks are removed, the law may hurt the very cause it seeks to help:  the retirement security of American employees.

The Congress now appears to have recognized the need to make defined benefit pension plans more appealing to business owners. In April 2004, President Bush signed into law the Pension Funding Equity Act, which diminished the impact of low interest rates on the level of pension plan underfunding.  The Act also temporarily reduced additional plan contributions required by underfunded plans in certain industries such as steel and airlines.

Nevertheless, a defined benefit pension plan is only appropriate if the employer is confident it will meet its contribution liability every year.  For such an employer, a defined benefit pension plan is an indispensable tool for providing retirement security to its employees, and gaining current tax advantages for itself.  It is the optimum strategy for older employees who have been deprived of plan benefits during the early part of their careers, or for principals who experience a sudden surge of cash flow.