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Types of Retirement Benefit Plans

October 11, 2017

Retirement plans can be workplace sponsored or they can be initiated and funded by individuals. Generally, there are two main categories of employer-sponsored retirement plans in operation today: defined benefit (DB) plans and defined contribution (DC) plans. Here's how they work:

 

Defined Benefit Plans (Traditional Pensions)

 

Defined benefit plans are more commonly thought of as "traditional pension" plans. The employer funds the plan and the plan is designed to pay a specific monthly or annual amount to qualified plan beneficiaries, based on their pay level. The plan sponsor, rather than the employee, controls the investments, and it's the plan sponsor, not the employee, that bears the burden of market risks: If returns on the plans are not enough to pay promised benefits, the employer is responsible for making up the difference out of operating income, borrowing, asset sales, or any other way they can raise the money. Failure to do so could result in bankruptcy proceedings for the company, which has a contractual relationship with plan beneficiaries to provide the promised benefits.

 

Defined Contribution Plans

 

Defined contribution plans significantly reduce costs and administrative burdens on plan sponsor employers, but they also pass on much more of the burden of funding, risk management and investment decision-making to the worker. There is no guarantee of any specific level of retirement income of any kind, with these plans. Instead, workers contribute whatever they can to the plans. Some employers also contribute matching funds or other contributions, but there is usually no requirement for them to do so.

Examples of defined contribution plans include 401(k) and 403(b) (tax-sheltered annuity plans).

There are other plans available for employers to explore, such as:

 

Cash Balance Plan

 

Cash balance plans take elements of both defined contribution and defined benefit plans and combine them into one. Employers enjoy greater control of their future obligations than they otherwise do. Under cash balance plans, the employer contributes a set amount to the plan each year, and guarantees a specific fixed rate of growth. Once the worker reaches retirement age, he or she has the option of taking a lump sum out of the plan or having the company annuitize it - i.e., convert the pension into a guaranteed stream of income.

 

Keogh Plan

 

These plans are fairly rarely seen these days. These are tax-deferred accounts for self-employed individuals or for people who work for business other than corporations.

Over the past couple of generations, we have seen a massive migration of workers from defined benefit to defined contribution plans. This is due to increased competition from foreign firms and longer lifespans among retirees making it more and more difficult for U.S. employers to keep functioning while still paying retirement benefits to a small army of retired workers.

SIMPLE IRA

 

The SIMPLE IRA is designed to be an alternative defined contribution benefit plan for employers with fewer than 100 workers. It costs less to set up and administer than 401(k) plans. Workers contribute what they would like to these plans, and employers may contribute as well but are not required to. However, if they do contribute, they must treat all plan members equally. They cannot pick and choose which members get a better matching contribution.

SEP IRA

 

The Simplified Employer Pension allows employers to contribute to a defined contribution plan on employees' behalf. However, self-employed workers can and often do set up their own SEP to cover themselves (as their own employee!)

Contributions can be up to 25% of the employee's compensation, or $54,000 for 2016.

 

Executive Bonus Plan

 

An executive bonus plan (Section 162) is a way for business owners or companies to provide additional supplemental benefits to key employees or executives of their choice. The benefits usually include life insurance policy death benefits as well as cash value accumulations that can be used as a retirement income supplement. With an executive bonus plan, the business can use tax deductible company funds to selectively provide valued benefits to key people. An executive benefit plan, used effectively, can be a valuable tool to attract and retain key executives.

Executive bonus plans are simple in design and easy to implement. The executive bonus plan works as follows:

  • The company provides the key executive with a bonus that is taxable as income to the recipient. The bonus is generally a deductible business expense for the company.

  • The bonus is used to purchase a whole life or universal life insurance policy that builds cash value that grows tax deferred. Access to the cash surrender value is restricted by the company until a specific date.

  • The life insurance policy, if properly structured, may provide an attractive benefit to the executive in the form of cash value growth. Any cash value accumulation will grow tax deferred and may be accessed by the employee income tax-free through withdrawals and policy loans. The policy’s cash value can be used to supplement retirement income or for any other financial need.

  • If the key executive dies, in most cases, the heirs will receive the death benefit proceeds from the life insurance policy income tax free.

To add or modify a plan, or to discuss which of these important retirement benefit plans may be best for your business, consult your employee benefits or retirement planning professional.

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