Defined Benefit Plans

A defined benefit plan is a sophisticated retirement strategy tailored to ensure participants receive predetermined benefits upon retirement. Contributions to the plan are determined by the benefits it promises.

To illustrate, let’s imagine an employee must accrue $100,000 to secure their retirement income starting at age 65. If they join the plan at age 55, their employer needs to contribute $10,000 annually for 10 years to meet this target. Conversely, if the same individual joins at age 45, giving the employer 20 years to accumulate the funds, the required annual contribution is cut in half to $5,000.

The plan’s performance, whether it earns or loses, directly impacts the employer’s annual contribution obligation. This design underscores the pivotal role of the accumulation period—the duration before retirement—in determining the contribution size. In essence, the shorter the accumulation period, the higher the necessary contribution typically becomes.

In defined benefit plans, annual contributions undergo adjustments, usually minor, compared to the prior year. This variability underscores the precise calculations to ascertain the necessary contribution for each participant, reflecting the commitments outlined by the plan. Furthermore, this calculation recurs annually, incorporating insights compiled from the plan’s past investment performance and forecasts regarding future participant salary escalations and investment returns.

Contributions to defined benefit plans are obligatory annually and are subject to variation. Apart from alterations in the pool of covered participants, these changes primarily hinge on the performance of plan assets. Specifically, they are contingent on whether the asset performance aligns with the growth assumptions integral to the annual actuarial calculation.

In this setup, the employer shoulders the investment risk inherent in the defined benefit plan, with all contributions typically originating from them. Consequently, the employer bears the responsibility of adequately funding the plan, irrespective of its investment outcomes. Consequently, favorable investment experiences may lead to decreased employer contributions, while unfavorable ones are likely to prompt increases.Given that an employer must ensure adequate funding for the stipulated benefits regardless of when a participant enters the plan, contributions to a defined benefit plan tend to be disproportionately higher for older employees compared to their younger counterparts. This discrepancy arises because older entrants typically have fewer years of plan participation before retirement, necessitating a more substantial allocation of annual contributions to meet their benefit requirements. Consequently, a larger portion of contributions are directed towards providing benefits for older employees. While younger employees will still receive their promised benefits, they are evidently not prioritized in terms of the allocation of contributions within a defined benefit plan.

Benefits within defined benefit plans often, though not universally, correlate with a percentage of the participant’s final compensation. In this scenario, the higher the participant’s earnings, the greater the required plan contribution to ensure adequate funding for their retirement income.

For instance, let’s consider two 45-year-old employees enrolled in a defined benefit plan committed to providing a retirement income equivalent to 60% of their final compensation. Employee A earns $50,000 annually, while employee B earns $100,000 annually. Assuming their incomes remain constant until retirement, Employee A would anticipate a monthly retirement income of $2,500 (($50,000 × 60%) ÷ 12 months = $2,500), whereas Employee B could expect $5,000 monthly. Evidently, the employer would need to make significantly higher contributions—potentially double—to meet Employee B’s benefit obligations.

In contrast, a target benefit plan offers a blend of features from both defined benefit and defined contribution plans. It provides substantial benefits to older participants comparable to those in defined benefit plans, while also allowing the potential for benefits to increase if the plan’s investments perform well. The trade-off, however, is that if the plan’s assets perform poorly, the actual benefit at retirement may fall short of the “target” benefit. This introduces an element of investment risk for participants, as their final benefits are directly influenced by the performance of the plan’s investments.

At the inception of a target benefit plan, an actuarial calculation is performed to establish the fixed contribution level required each year for each participant. Once these fixed contributions are determined, no further actuarial calculations are necessary. From this point forward, the plan operates like a defined contribution plan, accumulating funds in individual accounts set up for each participant. The retirement benefit each participant ultimately receives depends on the amount accumulated in their individual account, which is influenced by the performance of the plan’s investments.

In a target benefit plan, the investment risk is borne by the participant, similar to any defined contribution plan, such as a money purchase pension plan. If the plan’s investments perform better than the rate assumed during the initial actuarial calculation that determined the contribution level, the participant will enjoy a benefit higher than the plan’s target. Conversely, if the investments underperform, the benefit will fall short of the target.

A crucial aspect of target benefit plans is that the employer has no obligation to increase contributions to offset poor investment performance, nor can the employer reduce contributions in years when investment performance exceeds expectations. This contrasts with defined benefit plans, where the employer is responsible for ensuring that promised benefits are met regardless of investment performance.

Although target benefit plans incorporate elements of both defined benefit and defined contribution plans, they typically favor older participants. Older participants receive a greater percentage allocation of the fixed annual contributions because they have fewer years to accumulate the necessary funds for retirement. This results in a larger per-dollar allocation toward the target benefit for older employees. However, the actual benefit at retirement depends on investment performance, which can result in benefits that are either greater or smaller than the targeted amount.

Younger participants, on the other hand, benefit from a longer period for their contributions to accrue tax-deferred interest and compound in a tax-deferred environment. This extended accumulation period can significantly enhance their retirement benefits, especially if the plan’s investments perform well.

Overall, target benefit plans offer advantages to all parties involved. Employers benefit by not bearing the investment risk, which is shifted to the participants. Older employees receive a larger share of contributions due to their shorter time horizon, while younger employees benefit from potential long-term growth and compounding of their investments. This structure creates a balanced plan that caters to the needs of both older and younger participants.