10.1 Defined benefit and defined contribution plans
11 min read•august 20, 2024
Retirement plans come in two main flavors: defined benefit and defined contribution. Defined benefit plans promise a specific payout, while defined contribution plans grow based on contributions and investments. Each type has its own pros and cons for employers and employees.
Understanding these plans is crucial for financial planning. Defined benefit plans offer predictable income but less flexibility. Defined contribution plans give more control but shift to employees. Hybrid plans aim to balance the best of both worlds.
Types of retirement plans
- Retirement plans are an important component of employee benefits and financial planning for individuals
- The two main categories of retirement plans are defined benefit plans and defined contribution plans
- Hybrid plans combine features of both defined benefit and defined contribution plans
Defined benefit plans
Top images from around the web for Defined benefit plans
Topic 1: Governance of Pension Plans – Pension Finance and Management View original
Is this image relevant?
Defined Benefit Plan - Clipboard image View original
Is this image relevant?
Defined Benefit Plans - Free of Charge Creative Commons Suspension file image View original
Is this image relevant?
Topic 1: Governance of Pension Plans – Pension Finance and Management View original
Is this image relevant?
Defined Benefit Plan - Clipboard image View original
Is this image relevant?
1 of 3
Top images from around the web for Defined benefit plans
Topic 1: Governance of Pension Plans – Pension Finance and Management View original
Is this image relevant?
Defined Benefit Plan - Clipboard image View original
Is this image relevant?
Defined Benefit Plans - Free of Charge Creative Commons Suspension file image View original
Is this image relevant?
Topic 1: Governance of Pension Plans – Pension Finance and Management View original
Is this image relevant?
Defined Benefit Plan - Clipboard image View original
Is this image relevant?
1 of 3
- Provide a guaranteed retirement benefit based on a formula that considers factors such as salary and years of service
- Employer bears the investment risk and is responsible for ensuring sufficient funds are available to pay promised benefits
- Examples include traditional pensions and cash balance plans
Defined contribution plans
- Specify the amount of contributions made by the employer and/or employee to an individual account
- Retirement benefit depends on the performance of investments chosen by the participant
- Examples include 401(k) plans, 403(b) plans, and profit-sharing plans
Hybrid plans
- Combine features of both defined benefit and defined contribution plans
- May provide a minimum guaranteed benefit while also allowing for individual investment accounts
- Examples include cash balance plans with employee contribution options and pension equity plans
Defined benefit plans
- Defined benefit plans provide a predictable retirement income stream based on a formula specified in the plan document
- Key components of the benefit formula include final average salary, years of service, and a benefit multiplier
- Participants must meet requirements to be entitled to accrued benefits
Benefit formula
- Determines the amount of the retirement benefit based on factors such as salary and years of service
- Common formulas include:
- Final average pay formula: Benefit = (Final average salary) x (Years of service) x (Benefit multiplier)
- Career average pay formula: Benefit = (Average salary over career) x (Years of service) x (Benefit multiplier)
- Benefit multiplier typically ranges from 1% to 2.5% of salary per year of service
Final average salary
- The average of the participant's highest earnings over a specified period, such as the last 3 or 5 years of employment
- May be based on base salary only or include other compensation such as bonuses or overtime
- Used in the benefit formula to determine the retirement benefit amount
Years of service
- The length of time an employee has worked for the employer sponsoring the
- Used in the benefit formula to determine the retirement benefit amount
- May be subject to a maximum limit (e.g., 30 years) for benefit accrual purposes
Normal retirement age
- The age specified in the plan document at which a participant is entitled to receive unreduced retirement benefits
- Typically age 65, but may be earlier or later depending on the plan's provisions
- Participants who continue working past normal retirement age may receive actuarially increased benefits
Early retirement provisions
- Allow participants to begin receiving benefits before reaching normal retirement age
- Early retirement benefits are typically reduced to account for the longer payout period
- Reduction factors may be based on age, years of service, or a combination of both
Vesting requirements
- Specify the length of service required for a participant to earn a non-forfeitable right to accrued benefits
- Cliff vesting: 100% vested after a specified number of years (e.g., 5 years)
- Graded vesting: Gradually vested over a period of years (e.g., 20% per year, fully vested after 5 years)
- Participants who terminate employment before fully vesting may forfeit a portion or all of their accrued benefits
Funding defined benefit plans
- Employers are responsible for ensuring that defined benefit plans have sufficient assets to pay promised benefits
- Actuarial cost methods are used to determine the plan's funding requirements and allocate costs over time
- Actuarial assumptions, such as investment return and mortality rates, play a crucial role in the funding process
Actuarial cost methods
- Used to allocate the cost of benefits over the working lifetimes of plan participants
- Common methods include:
- Entry Age Normal: Allocates costs as a level percentage of pay from entry age to normal retirement age
- Projected Unit Credit: Allocates costs based on the present value of benefits earned in each year of service
- Aggregate: Spreads the total cost of benefits evenly over the average remaining service of all participants
Normal cost
- The portion of the present value of future benefits allocated to the current year under the actuarial cost method
- Represents the cost of benefits earned by participants during the current year
- Typically expressed as a percentage of payroll or a dollar amount
Actuarial accrued liability
- The portion of the present value of future benefits attributed to past service as of the valuation date
- Represents the value of benefits earned by participants up to the current point in time
- Calculated using the plan's actuarial cost method and assumptions
Unfunded actuarial accrued liability
- The difference between the actuarial accrued liability and the value of plan assets
- Represents the portion of accrued benefits not yet funded by plan assets
- May arise due to plan amendments, actuarial losses, or insufficient contributions
Amortization of unfunded liability
- The process of spreading the unfunded actuarial accrued liability over a period of years through additional contributions
- Amortization periods are typically 15 to 30 years, depending on the source of the unfunded liability
- Minimum funding standards set by ERISA and the Internal Revenue Code govern the amortization of unfunded liabilities
Actuarial assumptions
- Estimates of future events that impact the cost and funding of the defined benefit plan
- Key assumptions include:
- Investment return: The expected rate of return on plan assets
- Mortality rates: The probability of participants surviving to various ages
- Salary increases: The expected rate of future salary growth for participants
- Retirement rates: The probability of participants retiring at various ages
- Assumptions must be reasonable and based on the plan's experience and future expectations
Defined contribution plans
- Defined contribution plans specify the amount of contributions made by employers and/or employees to individual accounts
- Retirement benefits are based on the accumulated contributions and investment earnings in each participant's account
- Participants bear the investment risk and are responsible for making investment decisions
Individual account balances
- Each participant has a separate account that holds contributions and investment earnings
- Account balances are typically updated daily based on the performance of the selected investments
- Participants can view their account balances and make changes to their investment allocations
Employer contributions
- Contributions made by the employer to participants' accounts
- May be a fixed percentage of pay, a match of employee contributions, or a discretionary amount
- Employer contributions are tax-deductible and not taxable to participants until distributed
Employee contributions
- Contributions made by employees to their own accounts, typically through payroll deductions
- May be made on a pre-tax basis (traditional) or after-tax basis (Roth)
- Pre-tax contributions reduce the participant's taxable income in the year contributed, while Roth contributions provide tax-free growth and distributions in retirement
Investment options
- Defined contribution plans offer a menu of investment options for participants to choose from
- Options may include mutual funds, target-date funds, stable value funds, and company stock
- Participants are responsible for selecting investments and monitoring their performance
Vesting of employer contributions
- Refers to the participant's ownership of employer contributions and associated earnings
- Vesting schedules for employer contributions can be cliff or graded, similar to defined benefit plans
- Employee contributions and their associated earnings are always 100% vested
Distribution options at retirement
- Participants can typically choose from several distribution options when they retire or leave the employer
- Options may include:
- Lump-sum distribution: Receive the entire account balance in a single payment
- Annuity: Receive guaranteed payments for life or a specified period
- Installment payments: Receive periodic payments over a set number of years
- Rollover: Transfer the account balance to an Individual Retirement Account (IRA) or another employer's plan
Risks in retirement plans
- Both defined benefit and defined contribution plans are subject to various risks that can impact participants' retirement security
- Key risks include investment risk, , and inflation risk
- Understanding and managing these risks is crucial for plan sponsors and participants
Investment risk
- The risk that investment returns will be lower than expected, resulting in reduced retirement benefits
- In defined benefit plans, the employer bears the investment risk and must make up for any shortfalls
- In defined contribution plans, participants bear the investment risk and may have lower account balances if investments underperform
Longevity risk
- The risk that participants will outlive their retirement savings
- Defined benefit plans typically provide lifetime benefits, mitigating longevity risk for participants
- In defined contribution plans, participants must manage their account balances to ensure they do not outlive their savings
Inflation risk
- The risk that the purchasing power of retirement benefits will be eroded by inflation over time
- Defined benefit plans may offer cost-of-living adjustments (COLAs) to help protect against inflation
- In defined contribution plans, participants must invest in assets that have the potential to outpace inflation, such as stocks
Regulatory requirements
- Retirement plans are subject to various laws and regulations designed to protect participants' rights and ensure plan solvency
- Key regulatory requirements include ERISA, minimum funding standards, reporting and disclosure, and fiduciary responsibilities
- Plan sponsors must comply with these requirements to maintain the plan's tax-qualified status
ERISA
- The Employee Retirement Income Security Act of 1974 (ERISA) is a federal law that sets minimum standards for retirement plans
- ERISA provisions include:
- Participation and vesting requirements
- Funding and fiduciary standards
- Reporting and disclosure obligations
- Benefit accrual and payment rules
Minimum funding standards
- ERISA and the Internal Revenue Code set minimum funding standards for defined benefit plans
- Plans must make annual contributions sufficient to cover the and amortize any unfunded liabilities
- Failure to meet minimum funding standards can result in excise taxes and other penalties
Reporting and disclosure
- Plan sponsors must file annual reports (Form 5500) with the Department of Labor and provide participants with plan information
- Required disclosures include:
- Summary Plan Description (SPD): A plain-language summary of the plan's key provisions
- Annual Funding Notice: Information on the plan's and funding policy
- Benefit statements: Periodic updates on participants' accrued benefits or account balances
Fiduciary responsibilities
- Plan fiduciaries, including plan sponsors and investment managers, must act solely in the interest of plan participants
- Fiduciary duties include:
- Acting prudently and diversifying plan investments
- Following the plan document and complying with ERISA
- Paying only reasonable plan expenses
- Avoiding conflicts of interest
Accounting for retirement plans
- Employers must properly account for the costs and obligations associated with sponsoring retirement plans
- Accounting standards for retirement plans are set by the Financial Accounting Standards Board (FASB)
- Key aspects of retirement plan accounting include balance sheet recognition, income statement recognition, and footnote disclosures
FASB Accounting Standards Codification
- The FASB Accounting Standards Codification (ASC) is the single source of authoritative U.S. GAAP
- ASC 715, Compensation—Retirement Benefits, provides guidance on accounting for defined benefit and defined contribution plans
- Employers must follow ASC 715 when preparing financial statements
Balance sheet recognition
- For defined benefit plans, employers recognize the funded status of the plan on the balance sheet
- The funded status is the difference between the fair value of plan assets and the projected (PBO)
- Any unfunded obligation is recorded as a liability, while any overfunded status is recorded as an asset
Income statement recognition
- For defined benefit plans, the net periodic pension cost is recognized in the income statement
- Net periodic pension cost includes:
- Service cost: The present value of benefits earned by participants during the period
- Interest cost: The increase in the PBO due to the passage of time
- Expected return on plan assets: The assumed earnings on plan investments
- Amortization of prior service cost and actuarial gains/losses
Footnote disclosures
- Employers must provide detailed disclosures about their retirement plans in the footnotes to the financial statements
- Required disclosures for defined benefit plans include:
- Plan description and funding policy
- Reconciliation of the PBO and fair value of plan assets
- Components of net periodic pension cost
- Actuarial assumptions used in the calculations
- For defined contribution plans, employers disclose the amount of contributions recognized as expense during the period
Advantages and disadvantages
- Defined benefit and defined contribution plans each have their own advantages and disadvantages for employers and employees
- The choice between the two types of plans depends on factors such as cost, risk tolerance, and workforce demographics
- Many employers offer a combination of both types of plans to balance the pros and cons
Defined benefit vs defined contribution
- Defined benefit plans provide a predictable retirement benefit but expose the employer to investment and longevity risk
- Defined contribution plans offer more portability and flexibility for employees but shift the investment and longevity risk to participants
- Defined benefit plans are more complex and costly to administer, while defined contribution plans are simpler and more transparent
Employer perspective
- Advantages of defined benefit plans for employers:
- Can be a valuable tool for attracting and retaining employees
- Contributions are tax-deductible and can be used to manage cash flow
- Disadvantages of defined benefit plans for employers:
- Higher administrative costs and complexity
- Exposure to investment and longevity risk
- Potential for unfunded liabilities and increased contributions in poor market conditions
- Advantages of defined contribution plans for employers:
- More predictable and controllable costs
- Reduced administrative burden and fiduciary liability
- Disadvantages of defined contribution plans for employers:
- May be less effective in attracting and retaining employees
- Employees may not save enough for retirement, potentially impacting workforce management
Employee perspective
- Advantages of defined benefit plans for employees:
- Predictable retirement income stream
- Employer bears the investment and longevity risk
- Benefits are insured by the
- Disadvantages of defined benefit plans for employees:
- Lack of portability when changing jobs
- Limited control over investments and retirement planning
- Benefits may be reduced if the plan is underfunded or the employer faces financial difficulties
- Advantages of defined contribution plans for employees:
- Greater portability and control over retirement savings
- Ability to make investment decisions based on personal risk tolerance and goals
- Potential for higher returns through investment selection
- Disadvantages of defined contribution plans for employees:
- Retirement income depends on investment performance and individual savings rates
- Exposure to investment and longevity risk
- Requires more active engagement and financial literacy to manage retirement planning effectively
Key Terms to Review (18)
Actuarial present value: Actuarial present value (APV) is the current worth of a future cash flow or series of cash flows, considering the time value of money and the probability of occurrence. It incorporates factors such as interest rates and mortality rates to provide a realistic assessment of future liabilities or benefits, making it essential for evaluating pensions, insurance policies, and other financial products tied to life contingencies.
Benefit Obligation: Benefit obligation refers to the total amount of money a company is required to pay in the future for promised employee benefits, such as pensions or other post-employment benefits. This figure is critical for defined benefit plans, where the employer commits to provide specific retirement benefits, creating a liability that must be accounted for on the company's balance sheet. Understanding benefit obligations helps assess the financial health of an organization and its capacity to meet future benefit payments.
Contribution Limits: Contribution limits refer to the maximum amounts that an individual or employer can contribute to retirement plans such as defined benefit and defined contribution plans within a specified time period, typically a calendar year. These limits are set by regulatory authorities to ensure that contributions remain within acceptable thresholds for tax advantages and overall retirement savings equity. Understanding these limits is crucial for participants to optimize their retirement funding while complying with legal requirements.
Defined benefit plan: A defined benefit plan is a type of retirement plan in which an employer promises to pay a specific amount to employees upon retirement, based on factors such as salary history and years of service. This plan offers a predictable income stream during retirement, distinguishing it from defined contribution plans where benefits depend on investment performance. The financial obligations of a defined benefit plan create specific valuation challenges and require careful modeling to ensure the plan is adequately funded over time.
Defined contribution plan: A defined contribution plan is a retirement savings plan where the employer, employee, or both make contributions on a regular basis, and the final benefit received by the employee at retirement depends on the amount contributed and the performance of investments. This type of plan emphasizes individual responsibility for investment choices and account management, contrasting with defined benefit plans that guarantee a specific payout at retirement.
Discount rate: The discount rate is the interest rate used to determine the present value of future cash flows. It reflects the time value of money, accounting for the risk and opportunity cost of capital. A higher discount rate results in a lower present value for future cash flows, which is crucial for evaluating the financial health and obligations of retirement plans and pension funding strategies.
Employee Retirement Income Security Act (ERISA): The Employee Retirement Income Security Act (ERISA) is a federal law enacted in 1974 that sets minimum standards for most voluntarily established pension and health plans in private industry. ERISA's primary purpose is to protect the interests of employee benefit plan participants and their beneficiaries by providing guidelines for the establishment, maintenance, and operation of these plans. The act specifically affects defined benefit and defined contribution plans, ensuring they meet certain requirements for funding, disclosure, and fiduciary responsibilities.
Entry Age Normal Method: The Entry Age Normal Method is an actuarial cost method used to allocate the costs of a defined benefit pension plan over the working lifetime of an employee, ensuring that contributions made are level throughout their career. This method calculates the normal cost as a level percentage of pay from the employee's entry age until retirement, facilitating predictable funding and aiding in determining the overall liability of the plan. Its structure allows for efficient planning and funding of retirement benefits by smoothing the costs across different ages and salaries.
Funded Status: Funded status refers to the financial health of a pension plan, specifically the difference between the plan's assets and its liabilities. It is a critical measure that indicates whether a pension plan has enough assets to cover its future obligations to retirees. A positive funded status means that the assets exceed liabilities, while a negative funded status signals a shortfall that could impact the benefits payable to participants.
Hybrid Plan: A hybrid plan is a type of retirement plan that combines features of both defined benefit plans and defined contribution plans. This means that it offers a guaranteed benefit at retirement while also allowing for some level of employee contributions and investment control, creating a balance between security and flexibility in retirement savings.
Investment risk: Investment risk refers to the potential for loss or negative financial outcomes associated with investing, which can arise from various factors such as market volatility, interest rate changes, and economic downturns. Understanding investment risk is crucial as it influences decision-making for asset allocation, especially in the context of long-term financial strategies like pension plans and insurance reserves.
Longevity risk: Longevity risk refers to the potential financial uncertainty that arises when individuals live longer than expected, impacting the sustainability of retirement plans and pensions. This risk is particularly relevant for defined benefit plans, which promise a certain payout for life, as it can lead to higher-than-anticipated liabilities. It also affects valuation of pension assets and liabilities, requiring careful consideration of mortality improvements and demographic trends to ensure adequate funding.
Mortality tables: Mortality tables are statistical charts that provide information on the likelihood of death within a certain age group or population over a specified period. They are essential tools used in various fields, particularly in calculating life insurance premiums, evaluating pension plans, and assessing the financial viability of life contingencies. Mortality tables allow actuaries to estimate future liabilities and determine appropriate reserves needed to meet obligations.
Normal cost: Normal cost refers to the actuarially determined cost of benefits that are expected to be earned by employees in a given period, typically for a pension plan. It represents the portion of the total pension cost that is allocated to the current service period, emphasizing the importance of recognizing the value of benefits as employees work. This concept is vital for understanding how pensions are funded and managed over time, influencing both defined benefit and defined contribution plans, and impacting funding methods and actuarial cost methods.
Pension Benefit Guaranty Corporation (PBGC): The Pension Benefit Guaranty Corporation (PBGC) is a U.S. government agency that protects the retirement incomes of workers in private-sector defined benefit pension plans. When a pension plan fails, the PBGC pays out benefits up to certain limits, ensuring that retirees still receive a portion of their promised pensions even if the plan is underfunded or goes bankrupt. This helps provide financial security for retirees and encourages the continuation of defined benefit plans in the private sector.
Pension vs. Savings Plan: A pension is a retirement plan that provides a fixed sum of money to employees after they retire, based on their salary and years of service, while a savings plan allows individuals to save and invest their money for retirement, often with contributions from both employees and employers. Pensions typically guarantee income for life, while savings plans rely on individual contributions and investment performance. Understanding these differences is crucial in determining how individuals prepare for retirement and manage their finances over time.
Projected Unit Credit Method: The projected unit credit method is an actuarial technique used to determine the present value of future pension benefits, where the benefits are allocated to each year of service as employees earn them. This method is particularly important for assessing defined benefit pension plans, as it helps calculate the plan's liabilities based on the projected future salary increases and service years.
Vesting: Vesting refers to the process by which an employee earns the right to receive full benefits from a retirement plan, typically after a certain period of service. This concept is crucial in both defined benefit and defined contribution plans as it determines when employees can access their accrued benefits or employer contributions. The vesting schedule can influence employee retention and overall plan attractiveness, as employees may need to stay with the company for a specified time to fully benefit from the retirement plans offered.