Defined Benefit vs Defined Contribution

Have you been reading about retirement plans and seen the terms Defined Contribution plan and Defined Benefit plan? It's not always clear just what these terms refer to, but it's important for you to understand the various types of plans when you're trying to figure out which plan is best for your retirement goals and your business profits.

Defined contribution plan

A defined contribution plan is a retirement plan that requires that an individual "account" be set up for each participant in the plan -- even if the only participant in the plan is you. It's called "defined contribution" because you can only contribute a fixed maximum amount to the plan each year. The contributions aren't based on your expected retirement benefit, but rather on a percentage that's specified in the plan.

The most commonly recognized type of Defined Contribution plan is the 401(k) plan. With a Defined Contribution plan, a percentage of income is placed in an account to be invested each year. Retirement income is determined by the amount of money in each individual's account at retirement. If investment return is better than expected, more money is available for retirement. If investment return is less than expected, the retirement income may fall short of retirement needs.

These plans are frequently set up by self-employed people as single-participant plans (a "Keogh profit sharing plan", for example), but the rules require that you also must make provisions for any employees you might have now or at any time in the future.

Some other types of Defined Contribution plans include:

A PROFIT-SHARING PLAN

A Profit Sharing plan is a plan for sharing the profits of the business with the employees. Contributions are based on the profits of the business and thus may vary in percentage from year to year. Profit-Sharing Plans are more flexible. You designate a maximum percentage that you may contribute each year if you wish. So you can contribute anywhere from 0% to the designated maximum percentage each year. You can contribute up to 13.0435% to the profit-sharing plan on your behalf (for your account) and up to 15% to an employee's plan (again, the difference is because the contribution itself reduces your income).

A STOCK BONUS PLAN

A Stock Bonus plan is similar to a profit-sharing plan, but the payments are in the form of the company's stock.

Hybrid Plans

You may have what's called a "paired plan." For example, your Keogh might include a Profit-Sharing Plan and a Stock Bonus Plan, which is a fairly common mix.

If you're considering establishing a defined contribution plan, contact a professional pension plan consultant for advice, Advanced Corporate Planning, for instance (shameless plug).

Defined Benefit plan

A defined benefit plan is a retirement plan set up to pay a fixed annual amount to eligible employees during their retirement years. It's called defined benefit because your quarterly or annual contribution is based upon an actuarial determination of what the participants' retirement benefits should be, not on profits. The formulas look at how much money must be contributed NOW in order for there to be enough money to pay a FIXED amount of benefit(s) to recipients in the future. These projections use a reasonable expected rate of return.

With a Defined Benefit plan, the desired benefit at retirement is predetermined, and contributions are made each year to obtain the specified benefit goal. If investment return is greater than expected, smaller contributions may be needed in a given year. If investment return is less than expected, greater contributions may be required. At retirement, regardless of investment fluctuations, the desired benefit is obtained.

The maximum amount you can contribute to this each year is the SMALLER of:

1. $180,000, OR
2. Your average compensation from your three highest CONSECUTIVE calendar years. (For example, if the income from your three highest income years added up to $150,000, the maximum amount you could contribute would be $50,000.)

There are other rules that limit your contribution even more if benefits are to begin before age 65. If you're considering establishing a defined benefit plan, contact a professional pension plan consultant for advice, Advanced Corporate Planning, for instance (shameless plug).

Defined benefit plans are usually best for those within 20 years of retirement, because they allow larger annual contributions than defined contribution plans.

With many "baby boomers" reaching age 50, retirement planning has become a very important issue. If you have spent the last 20 years building a business and are now ready to begin building a nest egg, Defined Benefit plans allow small business owners to accumulate more retirement benefits in a shorter time frame than Defined Contribution plans. Who is a prime candidate for Defined Benefit plans? Small business owners over age 50 who want to place the greatest amount of income possible into a tax-deferred vehicle while writing off the contribution from their taxable income.

For example, assume a Defined Benefit plan is started for a 50-year-old making $120,000 annually. The first year, approximately 33 percent of pay, or $40,000, can be contributed to a Defined Benefit plan and written off as a tax deduction. Anticipated increases in necessary funding for the Defined Benefit plan would allow future tax-deductible contributions of more than 50 percent of compensation. In fact, by age 65, the contribution can reach 100 percent of pay, as shown in the following chart. The older the owner-participant when the plan is started, the greater the contribution.

Defined Benefit Pension Plans

• Defined benefit pension plans provide guaranteed income security to workers for their retirement; no matter what happens in the stock market, how long an employee lives after retirement, or whether he or she becomes disabled.(Guarantees are based on the claims paying ability of the employees base plan.)
• Employees are not subject to investment risk. Pension funds invest assets with an optimum mix of growth potential and risk. Studies show that individuals responsible for their own retirement income typically invest too conservatively, and thus do not adequately protect their retirement benefits from inflation.
• Retirement benefits are not dependent on employees' ability to save. Lower-income workers and workers facing declining incomes lose twice under defined contribution plans, where employer contributions are often tied to employee savings. While defined benefit plans often have mandatory employee contributions, their contributions provide workers a secure retirement.
• Defined benefit plans provide cost of living adjustments and pension formulas that are tied to the highest-paid years, which protect employees from inflation while they save throughout their working lives.
• Death and disability insurance, which are typically provided under defined benefit plans, provide income security for participants. Defined contribution plans provide no insurance benefit in case of an employee's death or disability; employees must purchase this coverage at additional cost.
• Defined benefit plans provisions can allow for portability with shorter vesting periods, reciprocity agreements, and buybacks for prior or related service. Defined benefit plans may also allow employee borrowing.
• With Defined Benefit plans employers benefit from the favorable investment performance of pooled pension fund assets. The wide range of investment options open to large funds makes it possible for employers to provide adequate benefits to employees while limiting contributions. Studies of some pension funds show that investment earnings have exceeded both actuarial assumptions and the interest credited to employee accounts over the last two decades.
• Defined benefit plans promote retirement savings among lower-income workers, by mandating a single, low level of employee contribution to participate.

Defined Benefit Formulas

Most defined benefit formulas, in order to meet the desired retirement income objectives, consider an employee's earnings level while working. A formula based on the average earnings paid over the entire period of participation in the plan is said to use a career average formula. If the benefits are based on average earnings during some shorter period of time near retirement, the formula is called a final average formula. A typical final average formula would average earnings over the last three or five years of employment or over the highest three or five consecutive years in the ten-year period preceding retirement. It relates benefits to an employee's earnings and standard of living just prior to retirement. This type of plan is more likely to satisfy income replacement objectives than is a career average plan because the initial benefit computation takes into account pre-retirement inflation.

The four basic defined benefit formulas are:

1. a flat amount formula, which provides a flat benefit unrelated to earnings or service;
2. a flat percentage of earnings formula, which provides a benefit related to earnings but which does not reflect service;
3. a flat amount per year of service formula, which reflects service but not earnings; and
4. a percentage of earnings per year of service formula, which reflects both earnings and service.

Regardless of the type of benefit formula chosen, only basic compensation is normally considered for benefit purposes. Bonuses, overtime, and other forms of extraordinary compensation are not included.

Defined Contribution Formulas

The contribution under this type of formula is usually expressed as a percentage of base earnings and is often contingent upon the employee's making a contribution. In most cases, the sponsor's contribution either matches or is a multiple of the employee's contribution. For example, the plan could call for the employee and the employer each to contribute 5 percent of compensation; or the employee contribution could be set at 3 percent of compensation with the employer contributing 6 percent.

Accumulated funds are applied at retirement to provide whatever pension benefits can be purchased. The amount of benefit varies with the age at which it is being purchased, the age at which benefit payments are to begin, and, interest rates available in the current market and/or guaranteed in an annuity purchase contract purchased by the pension plan's administrator. The benefit for any employee depends upon these individual characteristics, plan characteristics such as contribution levels and investment income, and the annuity rates available at retirement. The result is wide variation in benefit levels among different employees. This uncertainty as to benefits, while not a major problem, makes financial planning more complicated and can cause some problems for the plan.

Benefits Accrual

There's a basic difference in the ways in which Defined Benefit and Defined Contribution plans accumulate retirement benefits. This issue is the key to identifying the value of each type of plan. A Defined Contribution plan deposits an amount of money on a periodic basis to an employee's account; the contribution may be determined as a percentage of pay or as a flat dollar amount. Then, the employee invests this money to earn investment income on the deposited contributions. The account grows with future contributions and further investment income until such time as the employee elects to retire and take the account balance. Some Defined Contribution plans also allow the employee to convert the account balance into a periodic form of payment such as an annuity.

The Defined Benefit plan works in exactly the opposite way. An account balance isn't accumulated for the employee, but instead, each year the employer's aggregate contribution to the Defined Benefit plan "purchases" a periodic payment at retirement for each employee. An accrued benefit builds up for the employee that is then paid out periodically to the employee upon retirement. Some Defined Benefit plans allow conversion of the periodic payment to a lump sum balance at retirement so that the employee may take the entire interest from the Defined Benefit plan.

This distinction between Defined Benefit and Defined Contribution plans may not seem important on the surface, but it's critical in terms of how retirement income accumulates for an employee.

An Example

Let's look at an example. ABC Inc. has the ability to fund a retirement plan at a cost equal to 5.5 percent of payroll. Which approach - Defined Benefit or Defined Contribution - will allow ABC Inc. to accomplish its objectives more cost effectively?

The bulk of ABC Inc.'s employees consists of production, marketing, distribution and administrative staff that it expects to retain for a long period, possibly up to 30 years. However, there's significant turnover among the professional staff at ABC Inc. So much that, ABC Inc. expects few of its professional staff will remain with the company more than 10 or 15 years. ABC Inc. decides that it will implement a Defined Contribution plan, specifically, a profit sharing plan, for its professional staff and a Defined Benefit plan for the bulk of its' employees.

Why two different approaches? First, most of the companies that ABC Inc. competes with for professional staff have competitive profit sharing plans. More basic than this, however, Defined Contribution plans generally do a better job than Defined Benefit plans at rewarding short-service employees. On the other hand, the best way to deliver retirement income to long-service employees is through a Defined Benefit plan.

Stated as a lump sum benefit at separation, the Defined Contribution plan provides higher benefits at younger ages and shorter service than a similar - cost Defined Benefit plan. In contrast, lump sums under a Defined Benefit plan grow larger at later ages for older, long-service employees. This is why it's often said that the Defined Benefit plan is the most effective way of delivering true retirement income. ABC Inc. recognizes that its longer-service employees may not be rewarded in their early years of employment under a Defined Benefit approach. However, as these employees near retirement age, their benefit accruals will accelerate rapidly.

In a Defined Contribution plan the same percentage of pay, in this case 5.5 percent, is deposited into each employee's account. Remember, however, that in a Defined Benefit plan, employees don't actually receive contributions to their accounts. Instead, they accrue benefits to be paid on a periodic basis at retirement. To make sure we're comparing apples to apples, think of the employee in a Defined Contribution plan as converting the 5.5 percent contribution into a Defined Benefit-type annuity payment. This is what would happen if the Defined Contribution plan participant purchased an annuity from an insurance company each year for the 5.5 percent contribution.

At young ages, this purchase is very inexpensive and will produce relatively large annuity benefits. However, at older ages, this purchase becomes much more expensive, with the result that much less Defined Benefit annuity is purchased. This comparison explains why Defined Contribution plans are better in the early years of employment but not as generous in the later years of employment.

Employees who are hired later in life are more likely to remain with their employer until retirement than younger hires. Further, many older hires are brought into professional and executive positions as "imported" talent. Therefore, it becomes critical that employers craft their retirement programs to recognize the needs of older hires in light of the differences between Defined Benefit and Defined Contribution plans for this group. This may require that special plan provisions apply to these employees or that supplemental benefits be granted.

Hybrid Defined Benefit AND Defined Contribution Plans

Hybrid plans attempt to blend the advantages of Defined Benefit and Defined Contribution plans. These plans generally look like Defined Contribution plans but have all the bells and whistles of Defined Benefit plans, such as protection by the Pension Benefit Guaranty Corporation (PBGC) and employer-retained investment risk.

The bottom line is that no one plan can satisfy all the objectives of every employer. Defined Benefit and Defined Contribution plans each have their own specific advantages, depending on what the employer's objectives are. In fact, this is the reason most employers maintain both Defined Benefit and Defined Contribution plans. In doing so, they balance being competitive and creating savings opportunities for employees with the assurance that they're directing their resources toward the right employee groups. Like the basic ingredients in a recipe, each type of plan has its place in an employer's benefit program. The trick is putting a mix together that has the right measure of each.

If you're considering establishing a defined benefit or a defined contribution plan, contact a professional pension plan consultant for advice, Advanced Corporate Planning, for instance.