DEFINED BENEFIT PENSION PLANS

THE BASIC CONCEPTS

 BACKGROUND

Defined Benefit Pension Plans have been around for a long time. Back in the early 1950's most people completed high school and went to work at the factory located in the town they grew up in. The personnel manager described the rate of pay, overtime pay, and the company benefits package. Most often that benefits package contained (among other benefits) a Pension Plan. When asked about the Pension Plan, the personnel manager or the plan administrator explained to the employee that after reaching age 65 he or she could count on a monthly retirement income for the rest of his or her life equal to a percentage of his or her final pay. For example, the plan may have offered a benefit of 50% of final average salary over the last five years of employment. If Joe averaged monthly salary of $2,000, he could count on receiving a monthly benefit of $1,000 ($2,000 X 50%) for the rest of his life. As you can see, we are Defining Joe's retirement benefits, hence the name Defined Benefit Pension Plan. Since we are defining benefits in a Defined Benefit Plan, we must actuarially determine the amount that must be funded to the plan each year to end up with sufficient assets to pay promised retirement benefits. Sounds great for a large manufacturer, right? Not today. Many of today's employees work for several employers by the time they retire. The result is that many large employers cannot afford this type of plan and most employees would not stick around long enough to earn full pension benefits.

WHO SHOULD CONSIDER A DEFINED BENEFIT PLAN?

Small profitable employers that want high deductible contributions and wish to benefit higher-paid key personnel who are at least age 48. Also, it is important that non-key personnel be considerably younger.

WHY DOES IT WORK?

A Defined Benefit Plan works well because the company can contribute a very high percentage of pay for the principal(s) or owner(s) provided they are at least age 48. Why? Because there is a short period of time to fund high fixed benefits. In general, a Defined Benefit Plan allows the employer to fund for a lump sum retirement benefit of as high as $1,000,000 or more per employee provided the employee has established high enough salary. Consequently, the employee who earns $150,000 annually and is age 55 will require large annual company contributions in order to eventually walk away with a lump sum benefit of $1,000,000 in 10 years. In contrast, an employee who is age 30 will not require large contributions because the company would have 35 years to fund for a fixed benefit and during that time, plan earnings will fund a substantial portion of eventual retirement benefits.

ADDITIONAL CONSIDERATIONS

If you are a Sole Proprietor who is a candidate for a Defined Benefit Pension Plan consider incorporating. Why? Because large deductible corporate contributions escape payroll taxes where large deductible sole proprietor contributions do not. For example, suppose you have no employees, earn $150,000 annually and sponsor a Defined Benefit Pension Plan that requires an annual deductible contribution of $80,000. If you incorporate the contribution becomes a necessary company expense where you do not pay the 2.9% Medicare tax on the $80,000. This would result in an annual savings of $2,320 ($80,000 X 2.9%).

Santa Barbara

Pension Consultants, Inc

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