Securing the Future: Defined Benefit Plans

Defined benefit plans, or “pension plans,” are most commonly thought of as a benefit for the employees of large corporations. Increasingly, small business owners are setting up these plans for their employees, and self-employed individuals are establishing them for themselves.

Why? Because defined benefit plans can help attract and retain talented employees while also reducing a small business's tax burden.

What is a defined benefit plan?

Defined benefit plans provide eligible employees a set monthly benefit upon retirement. That amount is based on factors such as age, earnings and years with the company, rather than on the performance of fund investments. Employers are required to make sufficient annual contributions to ensure that the plan will contain sufficient assets to pay the promised retirement benefits to employees when they retire. The legal benefit limit is the lesser of 100% of each participant's average compensation, or $170,000.

Defined benefit plans generally reward long-service employees and can be designed to protect benefits from the effects of inflation. Since the benefit value reaches its highest level as employees approach retirement, the plan minimizes payouts to workers who leave the company early.

Because defined benefit plans are insured by the Pension Benefit Guaranty Corporation (PBGC), a federal agency, employees can have a high degree of confidence that they'll receive their accrued pension after retiring. While employers assume the risk of investing the funds, they may also realize some advantages. If asset returns exceed expectations, an employer will need to contribute less to the plan to deliver the promised benefit. Additionally, employers may choose to set up the plan to include incentives, such as subsidized early retirement benefits, for workers who meet certain goals or milestones in the company.

Defined benefit plans can also be structured to provide employees with a range of benefits, such as extra spousal benefits, disability benefits, cost-of-living adjustments and more.

Advantages

Because the benefits paid out of a defined benefit plan increase with the number of years served, offering a defined benefit plan at your company can boost employee loyalty and retention. But the plan offers another advantage for employers looking to reduce their companies tax liability while establishing retirement savings for themselves and their employees. Defined benefit plans allow employers to make contributions well above the $42,000 cap set on the more common defined contribution plans, such as a 401(k). As a result, defined benefit plans are frequently preferable for highly compensated employees.

Eligibility

Whether you are self-employed or are involved in a partnership, sole proprietorship or a C- or S-corporation, you can sponsor a defined benefit plan. Of course, the plans are most suitable for businesses with stable, significant incomes. Eligibility and coverage rules for defined benefit plans are essentially the same as for tax-qualified defined contribution plans.

Is a defined benefit plan right for you?

There are other factors to consider in determining whether a defined benefit plan is right for you. For example, the complexities of the plan may be more difficult to explain to employees than those of a defined contribution plan. Additionally, you must file certain IRS forms, pay premiums to the PBGC and comply with other rules. The sponsor will have to hire an actuary to value the plan on an annual basis and may also need one to help design and implement the plan. If appropriate for your situation, a defined benefit plan can help you reduce taxes, strengthen your business, and secure your financial future.