Traditional defined benefit pension plans have a longer history and broader precedent than any other type of retirement plan available today. They hold tremendous tax-saving potential for many small business owners, and their popularity will only increase as baby-boomer entrepreneurs near retirement age.
Like other tax-deductible retirement programs, Defined Benefit Pension Plans provide:
To these features Defined Benefit plans add a key distinctive:
A Defined Benefit Plan (DB plan, or DBP) is a retirement plan that calculates the benefits for individual Participants based on formulas in the Plan Document, such as 50% of pay paid monthly starting at age 65.
Pension Plans traditionally sponsored by large corporations are examples of Defined Benefit Plans. The same long-standing laws and regulations that govern the large corporate Pension Plans are available for small DB Plans covering just one or only a few Participants, with certain variations. The plan design features of small DB Plans can be especially beneficial for entrepreneurs approaching retirement.
A DB Plan is NOT an Individual Account Plan: the Participants' benefits are NOT based on segregated or allocated account balances. Instead, assets are held in an aggregated Trust fund that is available to pay all benefits when they come due. The actual benefits paid out from the Trust are determined by the Plan Formula and by certain Actuarial Assumptions. That is, benefits are determined solely based on calculations and are not affected by asset performance.
Because the benefits to be paid from a DB Trust are based on formulas and not asset performance, this means that the Employer bears the risk associated with the asset performance. The Employer's contributions to a DB Plan are determined based on the projected benefits for all employees compared against the aggregate Trust fund available to pay the benefits. Benefits are projected and valued and actuarial methods are applied to determine the level of contribution needed to fund the future benefits over a period of future years related to the future working lifetime of the Participants.
Varieties of Defined Benefit plans include:
A Cash Balance Plan is a type of Defined Benefit Plan. It is not an Individual Account Plan (Defined Contribution Plan) since each Participant's benefits are not determined by the performance of the assets held in an individual account for that Participant. However, it LOOKS a lot like an Individual Account Plan (such as a Profit Sharing Plan) because the benefits are related to a Hypothetical Cash Balance Account, with Hypothetical Employer Contribution Allocations and Hypothetical Interest Credits added each year. The Hypothetical Interest Credits are based on an Actuarial Assumption specified in the Plan Document, and are not related to the actual earnings of the Trust.
Because a Cash Balance Plan exhibits some characteristics of both Defined Benefit Plans and Defined Contribution Plans, it is often called a hybrid plan. This makes it both easier and harder to understand. It is easier for Participant's to think that they fully understand the Plan, but it is actually more complex and therefore more probable that they do not fully understand it.
The benefit paid from the Cash Balance Plan is not simply the Hypothetical Cash Balance Account. (Which is why it is called a hypothetical account.) Instead, the Hypothetical Account balance must be converted into an annuity payable at Normal Retirement Age. This future benefit can then be converted into a current Lump Sum Benefit. The resulting Lump Sum Benefit may be either equal to or greater than the Hypothetical Cash Balance Account.
A 401k Plan can be added alongside a Traditional Defined benefit Plan (DBP) or a Cash Balance Plan (CBP) to provide even greater contribution potential for the principals of a small business. The 401k feature permits all employees as well as the owners to make maximum deferrals from their salaries to their own accounts.
In addition, a modest amount of employer contributions can be made for each employee. For certain cross-tested plan designs, these modest employer contributions permit a much larger benefit to the principals in the related DBP or CBP. In addition, in an OFFSET plan arrangement, the modest employer contributions can reduce the net defined benefit plan benefit to $0 for rank-and-file employees.
A defined benefit plan:
Employers can generally contribute
(and, therefore, deduct) more than for
other types of plans.
Owners of small companies often find defined benefit pension plans to be the best vehicle for accumulating funds for retirement.