As seen in our 2023 EOY Newsletter: Click Here
Steven Semler, CPC, QPA, QKA
Employer-sponsored retirement plans fall generally into two categories: defined benefit plans and defined contribution plans. Both types of plans are designed to provide plan participants with benefits upon retirement. However there are a number of differences between the two types of plans which we will touch on here.
A defined benefit plan was once the dominant form of retirement plan prior to the 401(k) plan coming into existence 45 years ago in November 1978. “Your grandparent's pension” would provide a periodic payment, usually monthly, called an annuity with an amount typically based on their tenure of service with the company and in some cases their average salary as well. The payment of this benefit, the investment of the plan assets, and ensuring the plan remained adequately funded, were all the responsibility of the employer.
With the inception of the 401(k) plan, the move was underway to transfer the responsibility for providing retirement income from the employer to the employee. Many defined benefit plans had future benefit accruals frozen or the plans were terminated. It then became the employee's responsibility to provide for their own retirement savings by way of having deductions taken from their salary on a pre-tax basis and deposited to a trust account. The plan sponsor could choose to offer a matching contribution to the salary deferral and/or offer a profit sharing contribution, but they were not obligated to do so. Over time, changes were made in regulations to preclude discrimination in amounts that company owners and other highly compensated employees could deposit versus the non-highly compensated employees.
While "traditional" defined benefit plans have seen their best days pass by decades ago, a new form of defined benefit plan has become very popular. That is a "cash balance" plan, which is referred to as a hybrid plan since it is subject to the defined benefit plan regulations yet has the look and feel of a defined contribution plan. Participants are able to better understand their benefits, and therefore have a greater appreciation of the plan itself.
The major differences between a defined benefit and defined contribution plan are as follows. Depending on your point of view, each item can be considered a "pro" or a "con," so no judgment is being applied to each point.
Investment risk
With a defined benefit plan, the plan sponsor assumes all of the investment risk. If the plan assets decrease in plan value, larger contributions may be required in future years to make up for the loss. With a defined contribution plan, the entire investment risk is borne by the plan participant.
Asset management
A defined benefit plan will generally consist of one trust fund and the management of the plan assets is on the shoulders of the plan trustee(s) or a committee assigned by the trustees. Conversely, most 401(k) plans offer participant direction of plan assets through an asset provider with a dedicated website where participants can make investment elections, or through self-directed brokerage accounts. The plan sponsor must ensure that adequate fund choices are available to satisfy Department of Labor requirements, must monitor the performance and expenses of the investment alternatives, and make changes when advisable.
Benefit limits
As the name implies, a defined benefit plan states the amount of the benefit to be provided at retirement age in the form of an annuity in the plan document. The current IRS limit on the amount that can be paid in the form of a life annuity is $275,000 per year for 2024 (the "dollar limit") or the participant's highest three year average consecutive compensation if less (the "compensation limit"). The dollar limit is adjusted if the participant retires before age 62 or after age 65. There are also reductions if the years of plan participation or service are less than 10. The resulting plan contributions can be very high—hundreds of thousands of dollars—depending on the plan formula and the employee demographics.
A defined contribution plan on the other hand has a lower contribution limit. For 2024, the maximum annual addition is $69,000 from all sources (salary deferrals and employer deposits such as matching and profit sharing contributions). If a participant is over age 50, they can potentially deposit an additional $7,500 as "catch up" contributions once they reach the salary deferral limit of $23,000.
To summarize, the main difference in the limitations on defined benefit plans versus defined contribution plans is that defined contribution plans have a limit on how much can be allocated to a participant in any given year, whereas defined benefit plans limit how much can eventually come out of the plan when the participant retires.
Ultimate lump sum benefit
Many defined benefit plans offer a lump sum option in addition to the required annuity options. The largest possible lump sum that can be paid from a defined benefit plan, assuming the maximum benefit, is approximately $3.5 million at age 62. The maximum lump sum payable at other ages would be greater or lesser than this amount due to actuarial adjustments. A defined contribution plan has no limitations on the ultimate lump sum benefit that can be paid.
Administrative burden and expense
A defined benefit plan requires additional plan administration. An Enrolled Actuary must certify the plan has met the minimum funding requirement each year. The plan may be required to be covered under a federally-run insurance program which requires additional calculations, government filings, and the payment of a premium each year. Benefit calculations and forms are more complex due to the requirement of providing a number of annuity options in addition to the lump sum calculation (if available).
Defined contribution administration does not require this additional administrative burden, and the administration is less involved than with defined benefit plans.
Both types of plans are subject to compliance tests such as top heavy, coverage and nondiscrimination, and both types of plans must file an Annual Report (Form 5500) with the Department of Labor and the IRS.
Best of both worlds?
Many plan sponsors have chosen the "best of both worlds" by sponsoring both a cash balance plan and a 401(k) plan. Complex nondiscrimination testing is required, but large benefits can often be provided to certain key employees in a cash balance plan while the rank and file employees primarily benefit under the defined contribution plan. The success of this combined plan design depends on the demographics of the plan sponsor’s employees.
If you are interested in having Preferred Pension prepare an analysis of the feasibility of having such a combination of plans, please contact us at 908-575-7575 or info@preferredpension.com. Our New Business Consultants can discuss the requirements in further detail.