Understanding company pension plans

Pros and cons of defined benefit plans

Written by Kevin Hagen

Company pension plans are normally either defined contribution plans or defined benefit plans. In a defined contribution plan, the employer and/or employees make contributions to the plan and retirement benefits are based on the capital and accumulated earnings in each participant's share of the retirement fund. In a defined benefit plan, the retirement benefit is pre-determined and the retirement plan is funded to pay that benefit.

In a defined benefit plan, the retirement benefit is generally established as a percentage of final pay times years of service, a specific amount per month times years of service, or as an exact amount per month at retirement. In a unionized business, the benefit may be determined based on collective bargaining.

Historically, defined benefit plans were more common, but with the rise of 401(k), SEP, and simple IRA plans, the use of defined benefit plans has declined. But there may be good reasons for your business to consider setting up a defined benefit plan.

Pros and cons of defined benefit plans or company pension plans

Pros

• Predictable, guaranteed company pension plans are valued by employees and can help attract and retain the best employees.
• Benefits do not depend on investment returns of fund assets. This protects the beneficiaries against market volatility.
• The employer can contribute more than to other types of plans. Owners who are employed by the company can build up a retirement fund more quickly. And larger contributions mean larger tax deductions.
• Workers can earn a reasonable retirement benefit, even if they have not been covered by a retirement plan earlier in their careers.
• The collective investment of fund assets could result in higher returns. During upturns in the market the return on investment may reduce or eliminate the need for employer contributions, or benefits could be increased at a reduced cost.
• Earnings on company pension plans are tax-deferred until withdrawn, and distributions may be eligible for favorable tax treatment.
• Defined benefit plans can offer additional benefits such as death and disability insurance and survivors' benefits.

Cons

• Since benefits are guaranteed, a downturn in investment markets will increase the funding requirements. Volatile market conditions mean volatile contribution requirements. Creating a cushion requires higher contributions.
• Company pension plans are more complex and costly to administer. You will need an actuary to determine the funding levels.
• Lack of portability can be considered a disadvantage for the employee but may encourage them to stay with the company.

Solo defined benefit plans

Defined benefit plans are not just for large companies. If you are self-employed, you can set up a solo defined benefit plan. If you are nearing retirement age and have not saved enough, a defined benefit plan allows you to make much larger contributions to catch up quickly. The maximum annual target benefit that can be funded for tax year 2009 is $195,000 and is adjusted annually for inflation. The contributions would be a tax-deductible expense for your business.

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