Defined Benefit Plans

A defined benefit plan is one set up to provide a predetermined retirement benefit to employees or their beneficiaries, either as a certain dollar amount each month, or a percentage of compensation.

Employer contributions to a defined benefit plan are very complex to determine and require the work of an actuary. The assets of the plan are held in a pool, rather than individual accounts for each employee, and as a result, the employees have no voice in investment decisions. Once the plan is established, the employer must continue to fund it, even if the company has no profits in a given year. Since the employer makes a specific promise to pay a certain sum in the future, it is the employer who assumes the risk of fluctuations in the value of the investment pool.

Work Smart More information about the requirements for defined benefit plans (and qualified plans generally) can be found in IRS Publication 560, Retirement Plans for Small Business (SEP, SIMPLE and Qualified Plans). However, establishing and properly funding a defined benefit plan is extremely complex and requires the advice of a specialist in the employee benefit area.

The maximum annual contribution you can make in 2014 to a defined benefit plan is one that would be projected to yield a benefit equal to the lesser of $210,000 or 100 percent of the participant's average compensation for the three highest consecutive years.

Very few defined benefit plans provide for the benefits to be adjusted each year to reflect the effects of inflation (called the Cost of Living Adjustment, or COLA), so over the years of your retirement, the value or purchasing power of your benefits may shrink considerably.

The Pension Benefit Guarantee Corporation (PBGC). With a defined benefit plan, the employer is legally required to make sure there is enough money in the plan to pay the guaranteed benefits. If the company fails to meet its obligation, the federal government steps in. Defined benefit plans are the only type of pension insured by the PBGC. The insurance works similarly to the federal deposit insurance that backs up your bank accounts. If your plan is covered and the sponsoring company goes bust, PBGC will take over benefit payments up to a maximum amount. The insurance protection helps make your pension more secure, but it is not a full guarantee that you will get what you expected.

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