Defined Benefit vs. Defined Contribution Plans
Instead of accumulating contributions and earnings in an individual account like defined contribution plans (profit sharing, 401(k)), a defined benefit plan promises the employee a specific monthly benefit payable at the retirement age specified in the plan. Defined benefit plans are usually funded entirely by the employer. The employer is responsible for contributing enough funds to the plan to pay the promised benefits regardless of profits and earnings.
Employers who want to shelter more than the annual defined contribution limit ($54,000 in 2017 and $55,000 in 2018), may want to consider a defined benefit plan since contributions can be substantially higher resulting in fast accumulation of retirement funds.
The plan has a specific formula for determining a fixed monthly retirement benefit. Benefits are usually based on the employee’s compensation and years of service which rewards long-term employees. Benefits may be integrated with Social Security which reduces the plan’s benefit payments based upon the employee’s Social Security benefits. The maximum benefit allowable is 100% of compensation (based on highest consecutive three-year average) to an indexed maximum annual benefit ($215,000 in 2017 and $220,000 in 2018). Defined benefit plans may permit employees to elect to receive the benefit in a form other than monthly benefits, such as a lump sum payment.
An actuary determines yearly employer contributions based on each employee’s projected retirement benefit and assumptions about investment performance, years until retirement, employee turnover and life expectancy at retirement. Employer contributions to fund the promised benefits are mandatory. Investment gains and losses decrease or increase the employer contributions. Non-vested accrued benefits forfeited by terminating employees are used to reduce employer contributions.