Defined Benefit Plans

Most retirement plans, including 401(k), profit-sharing and 403(b), are called defined contribution (DC) plans because the amount "contributed" to the plan is known or "defined." The employee or the employer (or both) contribute to the employee's individual account at a set rate, such as 5 percent of pay. The future benefit of that individual account is not defined — the final account balance will fluctuate depending on how the underlying investments perform.

A defined benefit plan, on the other hand, promises a specified monthly benefit at retirement. The plan may state this promised benefit as an exact dollar amount, such as $100 per month at retirement. Or, more commonly, it may calculate a benefit through a plan formula that considers such factors as salary and service. The benefits in most traditional defined benefit plans are protected, within certain limitations, by federal insurance provided through the Pension Benefit Guaranty Corporation (PBGC).

Defined benefit plans are qualified retirement accounts that pay a specific benefit at the plan holder's retirement age. Defined benefit plans can be an excellent option for companies with older employees who wish to accumulate assets rapidly, or for high-revenue companies and small businesses that can afford to make higher contributions.

Advantages of a Defined Benefit Plan

• Accumulation – Lifetime defined benefit accumulation limit is approximately $2 million.
• Tax Deductions – Contributions to an individual defined benefit plan are a deductible business expense and offer the largest deductions available under current tax laws.
• Investment Options – The investment committee has greater flexibility in making investment decisions than with other retirement plan designs.
• Asset Protection – Plan assets are protected from creditors under current federal guidelines.
• High Benefit Limits – Maximum retirement benefit of 100 percent of average compensation for the three consecutive years in which the participant's compensation was the highest, up to a maximum of $200,000 for 2012.
• Known Benefit Amount – Unlike with defined contribution plans such as 401(k)s, employees know how much they will receive at retirement.
• Ability to Combine with Defined Contribution Plans – Can contribute maximum allowed amounts to a defined contribution plan and still fund a defined benefit plan.

Other Defined Benefit Plan Considerations

• Require actuarial projections and administrative maintenance, making these plans more expensive to establish and administer.
• Quarterly contributions required.
• The employer bears 100 percent of the investment risk and mandatory annual contributions are subject to market volatility.
• The employer is responsible for investment management, actuarial calculations and annual contributions.
• Subject to ERISA reporting.
• May require coverage by Pension Benefit Guaranty Corporation.