Defined Benefit Plans provide a retiremnent benefit payable as a lifetime annuity. Benefits are often a function of a participant's final average compensation and their years of employment or years of participation. While some plans offer a lump sum upon retirement, in lieu of the annuity form of benefit, the plan must express its benefit in the form of a lifetime annuity.
An example of a defined benefit plan is as follows:
Final average earnings: $36,000
Years of service: 10 years
Benefit formula: 5.0% per year of service
Monthly defined benefit for life: $36,000 x 10 years x 5.0% / 12 = $1,500
In our area of defined plan practice, we are often dealing with a closely held corporation which has one or more principals who will participate in the defined benefit plan. In certain situations, defined benefit plans offer unique opportunities which are not available in other qualified retirement plan designs. The primary advantage of a defined benefit plan is the ability of the principal to earn a benefit which can have a value in excess of the maximium contribution limits under ยง415 for defined contribution type plans ($51,000 for 2013). If the principal is willing to offer this guaranteed benefit to other employees in order to take advantage of higher limits, then a defined benefit plan may be a good fit. If there are multiple principals, a cash balance plan may be a better option.
The following is an illustration of a defined benefit plan.
| Employee | Age | Annual Compensation Rate |
Projected Annual Benefit |
Reserve Required Age 62 |
Total Annual Contribution |
| Principal | 52 | 255,000 | 195,000 | 2,472,561 | 170,420 |
| Sub-total | 255,000 | 170,420 | |||
| Staff1 | 35 | 45,000 | 73,837 | 936,237 | 11,032 |
| Staff2 | 30 | 40,000 | 72,464 | 918,828 | 7,395 |
| Staff3 | 25 | 35,000 | 70,005 | 887,653 | 4,989 |
| Sub-total | 120,000 | 23,416 | |||
| Grand Total | 375,000 | 193,836 | |||
| Ratio of Pirincipal to Employee | 7.3 to 1 |
Period for Final Average Compensation: 3 years
Normal Retirement Age: Age 62
Benefit Formula: 8.25% per year of service, up to 25 years
Vesting: 6 year graded
Normal Form of Benefit: Straight life annuity
Investment Return: 6.00% per annum
Projected Salary Increases: 2.00% per annum
Mortality Table: 1994 Reserving, projected to 2002
Benefits for staff members are capped at 100% of projected final three year average compensation at age 62.
Actual plan costs for staff members may be less than shown as the plan would likely be terminated upon retirement of the principal.