Defined Benefit Plans

Defined Benefit Plans

What are Defined Benefit (DB) Plans?
A DB plan is a qualified retirement plan where contributions to the plan are based on the participant’s age and compensation. The DB Plan’s eligibility and distribution options are the same as other qualified plans; however, an actuary calculates how much a company must contribute to meet the ‘benefit defined’ in the plan document.

How does a DB Plan work?
A DB plan provides a specific benefit at a participant’s retirement age. The plan’s actuary determines the value of that benefit in the form of a single sum. The DB plan must accumulate the funds to provide that benefit by the time the participant reaches retirement age. The plan accumulates funds through contributions and earnings. An older participant has less time until retirement and therefore less time for the plan to accumulate the funds required to provide his/her retirement benefit. Accordingly, the contribution on behalf of the older participant must be relatively high compared to those required for a younger participant.

Here is a simple example:

Participant Age Compensation Annual Contribution Benefit at Retirement
Owner 55 $230,000 $161,737 $1,890,666
Employee 21 $24,000 $1,667 $302,532

How can the IRS allow such disparity between the owners and employees contributions?

It only appears there is disparity between the benefits being provided to the two individuals in the example above. Actually, the plan is providing the same benefit to both participants. The plan is providing a similar retirement annuity as a percentage of income to both participants. The perceived disparity exists because the owner’s compensation is much larger than the employee’s compensation and the owner is older than the employee.

This fact pattern is not unusual among small employers. Accordingly, the DB plan can be an extremely  powerful  tool  enabling  the  small  business  owner  large  contributions,  while minimizing employee cost.

DB plans are much more flexible than the typical business owner might think. These plans should exist for at least 3 years unless terminated earlier for legitimate business reasons. Proper plan design and effective funding strategies can provide owners with the flexibility they need to annually contribute their desired amount. If the investments under perform, contributions should increase and likewise contributions will decrease if funds exceed plan expectations.  Furthermore, if an owner’s contribution objectives change considerably, the plan can be amended to provide the needed additional flexibility.

Cash Balance Plans

A solution to the employee confusion and owners with different ages

  • It’s a hybrid—a DB plan that feels very DC.
  • Participants receive a contribution credit (usually a % of pay) and interest credit based on a guaranteed rate.
  • Participants can “see” their "accounts" grow with contributions and earnings.
  • Partners of different ages receive the same benefit, as illustrated below:
Employee Age Compensation Annual Contribution
Partner A 51 $220,000 $85,000
Partner B 58 $220,000 $85,000
NHCE 31 $25,000 $4,000

*38.63% to Partners & 16% to Non Owners

Cash Balance + Safe Harbor 401(k) Combo

Actual contribution for one of our clients just recently calculated:

Employee Age Salary Cash Balance Cont Deferral PS Cont Total
Owner 1 59 $220,000 $100,000 $20,000 $14,283 $134,283
Owner 2 54 $220,000 $100,000 $20,000 $14,283 $134,283
Other NHCE 56 $120,000 $3,000 $6,600 $6,672 $16,272
    $560,000 $203,000 $46,600 $35,238 $284,838
8 NHCEs various $372,470 $9,312 unknown $20,710 $30,022
Total   $932,470 $212,312 $46,600+ $55,948 $314,860

*Over 85% to Owners & 9.5% to NHCEs