Defined benefit pension plans may still be an attractive retirement benefit option for small employers. This is especially true for small business owners who have been too busy growing their businesses to plan for their retirement. Because of their late start, they must make up for lost time. A defined benefit plan may be just the ticket.
Background and Basics
Historically, the defined benefit plan was the standard type of employer-sponsored retirement plan. In recent years, however, defined benefit plans have declined in popularity, as some employers have replaced them with defined contribution plans, such as profit-sharing plans and 401(k) plans.
Defined benefit plans provide specific benefits according to a formula that is usually based on the employee’s compensation and service with the employer. For example, a typical formula would be a percentage of average compensation for the highest five consecutive years for each year of service up to a maximum of 25 years. In contrast, defined contribution plans provide no specific benefit. Instead, the retirement benefit in a defined contribution plan is based on how much was contributed to the plan and how well the plan investments performed.
As a result of current legislation and regulations, defined benefit plans possess characteristics that can be appealing to small business owners. Consider the following:
- Counting of prior service allowance. Unlike most other plans, a defined benefit plan can count prior service with the employer in determining the benefit. This allows business owners, who may have delayed setting up a retirement plan until late in their careers, to make up for lost time.
- Higher contribution and deduction levels. Unlike defined contribution plans—where annual contributions are more limited—an employer sponsoring a defined benefit plan can generally contribute and deduct the annual amount necessary to fund the projected benefit.
- Higher benefit levels. Recent changes in IRS limits have increased benefit limits. For 2022, the maximum annual retirement benefit that a defined benefit plan can provide is $245,000.
There are also reasons why some small employers find defined benefit plans less attractive than defined contribution plans. These may include the following:
- Complexity. In general, a defined benefit plan is more complicated to administer than a defined contribution plan. Actuarial calculations must be performed on a regular basis, and the benefit formulas and benefit options can be complex.
- Cost. An actuary must be retained to perform annual calculations and valuations to help ensure the promised benefits are being adequately funded. Also, the Pension Benefit Guaranty Corporation (PBGC), a Federal agency, must insure the plan benefits. Annual premiums must be paid to the PBGC.
- Communication. Because of their complexity, the benefits provided by defined benefit plans can be difficult to communicate to employees. Some individuals may prefer 401(k) plans, where participants can regularly monitor the progress of their account balances.
If you are a small business owner, especially one who has gotten a late start in saving for retirement, ask your financial professional whether a defined benefit plan might be beneficial for you and your business.