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Defined benefit plans, often known as traditional pensions–which guarantee workers a set amount of money during retirement–have lost popularity with employers over the years. They have been replaced largely by defined contribution plans, such as the 401(k).
But the defined benefit plans remain popular with employees and it’s worth taking a look at them to see whether they could be a good recruitment and retention tool for a small business seeking to compete with the big firms for good workers.
Traditional plans’ benefits are typically calculated based on length of service or employment history and salary. Once an employee reaches a certain age or fulfills certain criteria, he or she can start collecting a set amount in the form of a pension. Typically that amount remains fixed for life and is not subject to variations in the stock market. An employee can elect to pass on some of the benefits to heirs or receive a higher lifetime amount with payments ceasing at his or her death. Some plans also allow a retiring employee to take a lump sum payment instead of receiving monthly checks.
An employer who offers a defined benefit plan is responsible for administering that plan and covering all of the costs involved. The employer is also tasked with making investment decisions and managing investments to keep the plan solvent; any risk is assumed by the employer.
So it’s not hard to see why many companies have shifted to defined contribution plans, which put most of the cost–and all of the investment risk–on workers. In 1998, 60 percent of Fortune 500 companies offered defined benefit plans to new hires, but by the end of 2017, that had fallen to just 4 percent. The trend may have saved companies money but it has left more and more employees with less financial security in retirement.
Traditional pension plans are still the norm for most public sector workers–teachers, firefighters, police officers, city and county employees and the like. Some leaders are sounding the alarm about underfunded public pension funds and pushing for reductions in benefits, so far with little success.
Unlike 401(k)s, defined benefit plans can’t be moved to the next employer, so they are most attractive to workers who tend to spend most of their careers with one company or public employer.
So why would an employer even consider offering a defined benefit plan, given the additional costs and risks?
Because employees like them. And they are increasingly wary of defined contribution plans. A recent CNN report and other studies have shown that 401(k)s and other defined contribution plans haven’t been as successful as many proponents had hoped. It turns out that when employees are given the choice of investing their own money for retirement, many invest far too little to cover their retirement needs.
According to the IRS, a business of any size can establish a defined benefit plan and a company can offer more than one type of retirement plan. Firms with defined benefit plans will need to file annually a Form 5500 with a Schedule B and have an enrolled actuary determine the funding levels and sign the Schedule B; benefits cannot be decreased retroactively.
Although defined benefits plans are more costly for employers and more complex to administer, there are several advantages:
- Substantial benefits can be provided and accrued within a short time – even with early retirement
- Employers can contribute (and deduct) more than under other retirement plans
- Plan provides a predictable benefit for retirement
- Vesting can follow a variety of schedules, from immediate to spread out over seven years
- Benefits are not dependent on asset returns
- Plan can be used to promote certain business strategies by offering subsidized early retirement benefits for themselves and their employees
Generally, the employer makes most of the contributions. Sometimes, employee contributions are required or voluntary contributions may be permitted.
A defined benefit plan may permit participant loans but generally cannot make in-service distributions to a participant before age 62.
Use a pension questionnaire to help you determine whether offering a defined benefit plan is right for your company.
Interested? Start the process early. Due the more complex nature of this plan, it’s best to start setting up this plan by December 1st of the year you plan to contribute. This gives us sufficient time to plan, set up, and discuss funding the plan before the end of the year.
Winnie Sun is among the highest followed financial advisors on social media. Follow her on Twitter @sungroupwp.