(I know I promised some 401(k) design examples, but I’m going to put that off until after the Spring/Summer Series.)
In the olden days, before smartphones and Spotify and 401(k) plans, we had rotary phones and transistor radios and defined benefit plans. Used to be if you worked for a company for maybe forty years, they had a going-away cake for you at the office, gave you a gold watch, and sent you off to collect your pension. That pension, with a monthly benefit guaranteed for the rest of your life, was a defined benefit plan. Ah, the good old days.
But enough nostalgia. Defined benefit plans may not be as popular as they once were, but they still have a big place in pension plan design.
A defined benefit plan is exactly what the name says it is: a plan in which the benefit is defined. The terms of the plan tell us what benefit an employee gets when she or he retires. Knowing that, we actuaries can determine what amount must be contributed each year so that, together with investment growth, there will be enough money accumulated for each employee as they retire and collect their pensions for the rest of their lives. In theory. In reality, employees get raises and promotions. They take time off or change jobs. Investments, fickle and uncooperative at times, don’t always do what we expected them to do. On top of all this, the plan can be amended, changing the original benefit into something else. All of which is good for the actuary, who likes to feel needed.
As an example of who might want a defined benefit plan, let’s look at a 52 year old owner with no employees and $120,000 in pay. He could contribute $30,000 to a profit sharing plan, $55,000 to a 401(k) plan, or, based on actuarial determinations, $150,000+ to a defined benefit plan.
You may remember what we said with age-based profit sharing plans, that an older person has fewer years to accumulate a benefit. If the owner above hires a 22 year old assistant, the contribution for that assistant will be significantly lower (as a percentage of pay) than the contribution for the owner.
Defined benefit plans, even more so than the other plans we discussed, are situation specific. We need to look at the employee census to see how well such a plan would work. But when it does work, it can be extremely rewarding for the owner. And when it doesn’t, we can consider a cash balance plan.
Next up: Cash balance plans.