Defined Benefit Plan
Defined benefit plans provide tax incentives to employers and participating employees, are usually funded entirely by the employer, yet employees may be required to voluntarily make contributions or contribute.
What is a defined benefit plan?
A defined benefit plan is a qualified employer-sponsored retirement plan that provides a fixed monthly amount at retirement. For example, the plan document may:
- Promise a set dollar amount (e.g., $200 per month upon the employee’s retirement)
- Base the monthly benefit amount on factors like salary or length of service — for instance, 2% of the employee’s average salary for each of the last 5 years of service
Like other qualified retirement plans, defined benefit plans provide tax incentives to employers and participating employees. These plans are usually funded entirely by the employer. However, employees can be required to make contributions or contribute voluntarily. The funds in traditionally defined benefit plans are typically federally insured through the Pension Benefit Guaranty Corporation.
What employers and employees like about these plans
- Defined benefit plans enable businesses to contribute, and subsequently deduct, more annually than defined contribution plans (such as 401(k) plans).
- For 2022, the IRS hard dollar limit for defined benefit plan contributions is $245,000.
- Benefits are not contingent on asset returns.
Disappointments that some have experienced
- Defined benefit plans are more complex to administer than other types of retirement plans. This makes them more expensive to set up and maintain.
- The IRS has minimum participation and contribution rules for defined benefit plans.
- Failure to meet the minimum participation and contribution requirements may lead to penalties.
If you offer a defined benefit plan
- You can sponsor other types of retirement plans
- Your company can be of any size
- You must file a Form 5500 and Schedule SB annually
- Companies cannot retroactively reduce benefits
- You must have an enrolled actuary who handles certain duties, such as determining funding levels and signing the Schedule SB
The importance of defined benefit plans to HR leaders and small businesses
As with most things, defined benefit pension plans have pros and cons. HR leaders must examine the upsides and downsides when deciding whether to offer a defined benefit plan. Additionally, HR leaders must know the legal requirements under the Internal Revenue Code and the Employee Retirement Income Security Act. Most employers today offer a defined contribution plan — for example, a 401(k) — instead of a defined benefit plan. Small businesses, in particular, might not be equipped to handle the heavy responsibilities and costs of a defined benefit plan. That said, a defined benefit plan might be ideal for some businesses, such as those with very few employees.
The history of defined benefit plans
Defined benefit plans were first introduced in the United States during the Revolutionary War, which lasted from 1775 to 1783. They materialized as a result of the government promising pension benefits to veterans of the Revolutionary War. Over time, defined benefit plans grew in popularity, with employers independently funding the programs. Defined benefit plans began losing momentum when defined contribution plans started to gain steam. Unlike defined benefit plans, defined contribution plans place the responsibility of saving for retirement mostly on employees.
Summary
Defined benefit pension plans are qualified retirement plans that let employers provide a fixed, pre-established amount at retirement. For example, employers can pay $200 per month or tie the monthly benefit amount to salary or length of employment. Defined benefit plans have their strong points, including a much higher annual contribution limit. But they are more complicated and costly to establish and manage than other types of retirement plans. For these reasons, most employers choose to offer defined contribution plans instead of defined benefit plans. HR leaders and small businesses should carefully consider the advantages and disadvantages of defined benefit plans before adopting them.
