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Defined Benefit Plans

Defined Benefit Plans

Defined Benefit Plans are the type of traditional pension plans that have been in the news a lot lately. Bad press aside; these plans can be excellent tax and retirement savings vehicles for small businesses.

This type of plan promises a specified monthly benefit at retirement. The plan may state this promised benefit as an exact dollar amount, such as $100 per month at retirement. Or, more commonly, it may calculate a benefit through a plan formula that considers such factors as salary and service — for example, 5 percent of average salary for the last 5 years of employment for every year of service with an employer.

The employer is responsible for making annual contributions that are sufficient for funding the promised benefit. The required annual contributions are calculated by an actuary using minimum funding standards designed to ensure that the value of benefits accumulated and the plan’s assets bear a reasonable relationship to one another. Contributions are made to a pension trust fund that is invested on behalf of the plan participants.

Defined Benefit plans are complex and may be difficult for employees to understand. Many predict that the future of defined benefit plans will trend towards cash balance plans rather than traditional plans.

Cash Balance Plan

A Cash Balance Plan is a defined benefit plan that defines the benefit in terms that are more characteristic of a defined contribution plan. In other words, a cash balance plan defines the promised benefit in terms of a stated account balance. In a typical cash balance plan, a participant's account is credited each year with a "pay credit" (such as 5 percent of compensation from his or her employer) and an "interest credit" (either a fixed rate or a variable rate that is linked to an index such as the one-year treasury bill rate). Increases and decreases in the value of the plan's investments do not directly affect the benefit amounts promised to participants. Thus, the investment risks and rewards on plan assets are borne solely by the employer. When a participant becomes entitled to receive benefits under a cash balance plan, the benefits that are received are defined in terms of an account balance.

The benefits in most cash balance plans, as in most traditional defined benefit plans, are protected, within certain limitations, by federal insurance provided through the PBGC. Plans are exempt from PBGC coverage if there are no common-law employee participants.