A defined benefit plan is a type of pension plan in which a plan sponsor promises a specified monthly benefit upon attainment of the Plan’s Normal Retirement Age. This benefit is predetermined on a formula basis, using the employee’s earnings history, tenure of service and age. It is not affected by the Plan’s investment returns.

In short, this type of Plan defines the benefit or the amount of money to be received each month by the participant. This “monthly defined benefit” can be as high as 100% of the participant’s highest consecutive 3 year average monthly compensation based on years of service with the company. Such amount is limited by a dollar limit established under IRS regulations. For 2016 the annual dollar limit is $210,000 or $17,500 on a monthly basis for retirement age 62 through 65. Such amount is reduced for less than 10 years participation in the plan. For retirement ages above age 65, the dollar limit is increased according to IRS regulations. This dollar amount is further reduced if participation in the plan is less than 10 years.

An actuarial valuation determines how much needs to be contributed to the plan each year in order to build the required “lump sum”. The lump sum is the amount of money needed to fund the participant’s monthly benefit at retirement age. Upon reaching retirement age, participants usually elect to make a one-time rollover of the lump sum into a personal Individual Retirement Account (IRA), rather than draw the benefit as an annuity. The investment risk in a Defined Benefit Plan is assumed by you as the employer. If the actual investment earnings are greater than earnings assumed in the actuarial valuation, the employer’s cost to fund the plan would generally decrease. Likewise, if the earnings are less than those assumed in the actuarial valuation, the employer’s cost would generally increase. This increase or decrease is amortized over the future life of the Plan.

Pros Cons

Substantial benefits can be provided and accrued within a short time – even with early retirement

Administratively complex plan if there are multiple owners/partners in the business

Employers may contribute (and deduct) more than is permissible under other retirement plans such as Defined Contribution Plans

Administration and compliance is expensive, though the cost benefits work out in favor of the sponsor

Plan provides a predictable and guaranteed benefit, and the benefits are not dependent on asset returns

An excise tax may be applicable if the minimum contribution requirement is not satisfied

Vesting can follow a variety of schedules from immediate to grade over a six year period

An excise tax may be applicable if excess contributions are made to the plan resulting in over funding

Plan can be used to promote certain business strategies by offering subsidized early retirement benefits