Definition of Defined Benefit Retirement Plan
Retirement plans make up one of the biggest tax expenditures in the entire Internal Revenue Code. There are several types that vary by how benefits are paid, how benefits are earned and the complexity of the benefit plan. Generally employers offer either a defined contribution retirement plan, such as a 401(k) plan, or a defined benefit plan.
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Basics
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A defined benefit plan is a traditional retirement program. Commonly known as DB plans, these retirement programs provide for a benefit to be paid in a specific amount to a participant at retirement. Benefits can be promised to be paid in a specific amount or through a formula.
Benefit Limits
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Federal law sets a limit on the amount of a participant's annual benefit. For 2010, a participant's annual benefit cannot exceed the lesser of $195,000 or 100 percent of the participant's average compensation for three consecutive calendar years in which she earned the most compensation. The dollar limitation is adjusted annually for cost of living increases.
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Benefits
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The biggest benefit of a DB plan to a participant is that the risk of loss is on the employer, as the employer is responsible for determining the plan's investment strategy and allocations. Additionally, participants can plan better for retirement as they will know what benefit they will be paid when they retire.
Employers like DB plans because they can contribute and subsequently deduct more with their contributions to DB plans than to other retirement plans.
Drawbacks
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Participants lack any control over the amount of benefit they can earn. Moreover, participants do not have the ability to select how their retirement benefit is invested.
The drawbacks to DB plans for employers are that they are the most expensive type of retirement plan to offer employees. DB plans are also the most complex retirement plans to administer. In general, DB plans are not as flexible as other retirement plans since there are rules that require minimum contributions.
Federal Pension Insurance
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Most benefits offered through DB plans are protected at the federal level through the Pension Benefit Guaranty Corporation (PBGC). The PBGC is an insurance program that is supported by premiums paid by the plan sponsors whose plans are protected by the PBGC. The PBGC takes over plans and pays benefits when the plan does not have enough money to pay benefits.
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References
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