- How They Work
- Advantages and Disadvantages
There are three types of pension plans which are defined benefit, cash balance and money purchase plans. All require mandatory employer contributions.
Defined Benefit Plans
Here the employer guarantees a specific payment at retirement, such as 50% of the participant’s final average 3 year’s compensation payable for life. The employer is responsible for paying this benefit regardless of the plan’s investment performance. Each year, the plan is subject to an actuarial valuation to determine if the plan is on track to having enough money to pay the promised benefit. If it looks like there is going to be a shortfall, the employer’s contribution is more. If it appears that there will be a surplus, the contribution will be less.
From a business owner’s perspective, the main advantage of defined benefit plans is that employer contributions can be much larger than with other types of plans, such as 401k and profit sharing plans. Because retirement plan contributions are a deductible business expense, the owner can shelter a great deal of income from current taxation. In some cases, several hundred thousand dollars per year for a single individual. Defined contribution plans, on the other hand, are subject to the annual additions limit, which in 2021 is $58,000 increasing to $64,500 for those eligible for the 401k catch-up provision. With defined benefit plans, the limitations are placed on retirement benefits, not annual employer contributions. Currently, amounts received at retirement cannot exceed the lesser of 100% of compensation or $230,000 per year.
If you are thinking about establishing a defined benefit plan, consider the following:
- Do you really need to shelter more than the $58,000 or $64,500 permitted under a profit sharing and 401k plan?
- How predictable is your income? Remember contributions are mandatory.
- Are you willing to assume all investment risk? You are guaranteeing plan benefits regardless of the plan’s investment performance.
- Do the demographics of your company support a plan of this type? Defined Benefit plans work best when company owners are considerably older and much higher paid than their employees.
Cash Balanced Plans
These are defined benefit plans with some characteristics of a defined contribution plan. Here the employer chooses a retirement benefit and then funds it through a hypothetical interest rate. The hypothetical rate is not based on the plan’s actual investment returns. Rather it is an assumption guaranteed by the employer.
Cash balance plans have the same advantages and disadvantages as defined benefit plans. That is they are not subject to the annual additions limit so it is possible to shelter a great deal of income from current taxation. The disadvantages are that contributions are mandatory and that the employer assumes all investment risk.
Money Purchase Plans
These are defined contribution pension plans that are no longer in common use. Employer contributions are mandatory and are a percentage of the participant’s compensation.
They were popular a number of years ago when profit sharing plan contributions were limited to 15% of eligible payroll. At the time the limit for money purchase plans was 25% of eligible payroll. Eligible payroll is the total compensation of all employees eligible to participate in the plan.
Since that time, the profit sharing limit has increased to 25% of eligible payroll, so there is not much need for money purchase plans. The employer can contribute the same amount under a profit sharing plan without contributions being mandatory.