A defined benefit plan — also known as pension plans or qualified-benefit plans — is one of the oldest retirement plan options, with pension plans dating back to the post-Revolutionary War era. Though these types of plans are no longer popular among private companies, they are still common in state and local government sectors.
What is a defined benefit plan?
These plans provide a fixed, pre-established payout to employees at retirement, regardless of market conditions.
To calculate an employee’s benefits, a complex formula takes into consideration factors like employment tenure and salary history. For example, a plan may offer 1% of the average salary for the last 5 years of employment for every year of service with the employer. These benefits are typically protected by federal insurance through the Pension Benefit Guaranty Corporation.
Who can offer a defined benefit plan?
A business of any size or entity is qualified to offer a defined benefit plan. You can also offer this in conjunction with other benefit plans.
If you do decide to offer a defined benefit plan, the IRS stipulates that you:
- Need to annually file a Form 5500 with a Schedule SB
- Have an enrolled actuary determine the funding levels and sign the Schedule SB
- Cannot retroactively decrease benefits
Who contributes to a defined benefit plan?
The employer is generally responsible for most, if not all, contributions. Though uncommon, some plan setups allow — or even require — employee contributions. Unlike defined contribution plans (like a 401k), the employer bears all investment risks.
How are defined benefit plans paid out?
There are a few options for paying out a defined benefit plans at retirement:
- Single-life annuity: This provides a fixed, monthly payout until the retiree’s death.
- Single-life with term certain annuity: This provides a fixed, monthly payout for a specific term. If the retiree dies before this set term is over, beneficiaries can still receive payments until the term is complete.
- Qualified joint and survivor annuity: The surviving spouse continues to receive monthly payouts even after the former employee’s death. These can either equal 50% or 100% of the original annuity.
- Lump sum payment: The plan’s entire value is made in a single payment.
Each individual defined benefit plan stipulates how payouts are made, with some offering employees the ability to choose how they’d like to receive payouts. Distributions from a defined benefit plan are taxed as ordinary income.
Are there benefit limits to a defined benefit plan?
For 2023, the IRS stipulates that the annual benefit for a participant cannot exceed the lesser of:
- 100% of the participant's average compensation for their highest 3 consecutive calendar years or
- $265,000 for 2023
These annual benefit limits are subject to cost-of-living adjustments for future years.
The IRS also requires employers to make minimum annual contributions. An actuary, who determines how well the plan is funded each year, will calculate this required minimum contribution. Typically, this contribution number changes each year.
Not too hot, not too cold: the IRS is like Goldilocks, stipulating that contributions fall within a required range. If a company either does not meet minimum contribution requirements or exceeds contribution limits, an excise tax applies.
Should your business consider offering a defined benefit plan?
There are advantages and disadvantages to offering a defined benefit plan.
Because many defined benefit plans require a vesting period, this can reduce employee turnover and promote employment longevity. Additionally, employees appreciate knowing they will receive a fixed amount at retirement, regardless of market fluctuations.
Since the IRS classifies this type of plan as a qualified employer-sponsored retirement plan, certain employer contributions are eligible for tax deductions. That can mean higher tax deductions for companies than with other retirement plan types.
But because the employer funds most of the plan, a defined benefit plan is the most complex and costly to establish and maintain when compared to other types of retirement plans.
Build out the right retirement plan by working with a Landmark advisor
When you work with a Landmark financial advisor, we’ll help you build out the right benefits package for your business and employees.