Defined Benefit Pension
Plan
Chapter 14
Employee Benefit & Retirement Planning
What is it?
A qualified employer pension plan that
guarantees a specified benefit level at and
during retirement
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Defined Benefit Pension
Plan
Chapter 14
Employee Benefit & Retirement Planning
When is it indicated?
• employer’s plan design objective is to provide an
adequate level of retirement income to employees
regardless of their age at plan entry
• employer wants to allocate plan costs to the
maximum extent to older employees
• older controlling employee in a small business wants
to maximize tax-deferred retirement savings
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Defined Benefit Pension
Plan
Chapter 14
Employee Benefit & Retirement Planning
Advantages
1. employees gain tax-deferred retirement savings
2. can provide adequate retirement levels for
employees regardless of age at plan entry
3. benefit levels guaranteed by employer and Pension
Benefit Guaranty Corporation (PBGC)
4. plan generally allows maximum amount of taxdeferred retirement saving for older highly
compensated employee
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Defined Benefit Pension
Plan
Chapter 14
Employee Benefit & Retirement Planning
Disadvantages
1.
higher plan installation and administrative costs
than defined contribution plans
2.
complex design; difficult to explain to employees
3.
employees who leave before retirement may
receive relatively little benefit from plan
4.
employer has recurring annual funding obligation
regardless of business profit levels
5.
employer assumes investment risk
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Defined Benefit Pension
Plan
Chapter 14
Employee Benefit & Retirement Planning
Design Features
Several formulas can be used to determine benefit
promised at retirement
Flat amount formula
provides stated dollar amount to each plan participant
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Defined Benefit Pension
Plan
Chapter 14
Employee Benefit & Retirement Planning
Design Features
Flat percentage formula
–
retirement benefit is % of employee’s average earnings
–
typically requires minimum service for full % benefit with
% scaled back for fewer years of service
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Defined Benefit Pension
Plan
Chapter 14
Employee Benefit & Retirement Planning
Design Features
Unit credit formula
–
retirement benefit based on employee’s service with
employer
–
typically provides % of earnings for each year of service
–
two common methods to compute average earnings
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Defined Benefit Pension
Plan
Chapter 14
Employee Benefit & Retirement Planning
Design Features
Unit credit formula – average earnings
career average
average earnings over employee’s entire
career with employer
final average
average earnings over number of years;
usually 3-5 years before retirement
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Defined Benefit Pension
Plan
Chapter 14
Employee Benefit & Retirement Planning
Tax Implications
1. employer contributions to plan are deductible when
made
2. contributions and earnings tax deferred for
employee for qualified plans
3. IRS Code Section 415 places maximum limit on
projected annual benefit plan can provide
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Defined Benefit Pension
Plan
Chapter 14
Employee Benefit & Retirement Planning
Tax Implications
4. rules for qualified plan distributions must be
followed; premature distributions may be subject to
penalty
5. IRS Code Section 412 sets minimum funding rules;
employer penalized if minimum not met
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Defined Benefit Pension
Plan
Chapter 14
Employee Benefit & Retirement Planning
Tax Implications
6. mandatory coverage by PBGC, employer must pay
premium of $30 per participant plus amount
calculated on basis of plan’s unfunded vested
benefits, if any
7. certain employers adopting new plan may be eligible
for business tax credit up to $500
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Defined Benefit Pension
Plan
Chapter 14
Employee Benefit & Retirement Planning
Tax Implications
8. plan may permit employer contributions to “deemed
IRA”; such contributions reduce limit for other
traditional or Roth IRA contributions
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Defined Benefit Pension
Plan
Chapter 14
Employee Benefit & Retirement Planning
ERISA Requirements
Plan subject to ERISA requirements for qualified plans,
including:
– participation
– funding
– vesting
– reporting
– disclosure
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Defined Benefit Pension
Plan
Chapter 14
Employee Benefit & Retirement Planning
Alternatives
Money purchase plans
–
lack employer guarantee of benefit levels
–
provide adequate benefit only for younger employees
Target benefit plans
–
lack employer guarantee of benefit levels
–
may provide adequate benefit for older employees
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Defined Benefit Pension
Plan
Chapter 14
Employee Benefit & Retirement Planning
Alternatives
Cash balance pension plan
– employer guarantees principal and investment earnings on
plan fund
– provide adequate benefit only for younger employees
Profit sharing and similar plans
– benefit adequacy tied closely to employer financial success
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Defined Benefit Pension
Plan
Chapter 14
Employee Benefit & Retirement Planning
Alternatives
Section 401(k) and similar plans
– employees have some control over amount saved
Private savings outside qualified plan
– except certain IRAs, lack tax benefits of saving in a
qualified plan
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Defined Benefit Pension
Plan
Chapter 14
Employee Benefit & Retirement Planning
Application Exercise
Jill Cummings is retiring this year. She has worked for
Allied Enterprises for 25 years. Her last five years of
salary are: $55,000, $56,000, $58,000, 60,000 and
$61,000. Her average earnings over her career with
Allied are $42,000.
Compute Jill’s retirement income from Allied under the
following situations:
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Defined Benefit Pension
Plan
Chapter 14
Employee Benefit & Retirement Planning
Application Exercise
Consider each situation independent.
1.
Allied provides retirees $600 per month per life
2.
Allied provides retirees with 15 years or more years of
service 50% of average annual pay
3.
Allied provides retirees with 1.6% of earnings for each
year of service using
a.
b.
4.
career average earnings
final average earnings
Name each of the previous defined benefit plan formulas.
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Defined Benefit Pension
Plan
Chapter 14
Employee Benefit & Retirement Planning
Discussion Question
What is the impact of nondiscrimination regulations on
defined benefit plan design, especially for older owneremployees of closely held businesses?
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