Definition of Defined Benefit Plan
What is a defined benefit plan?
A defined benefit plan is a qualified employer-sponsored retirement plan that provides a fixed monthly amount at retirement.
For example, the plan document may:
- Promise a set dollar amount (e.g., $200 per month upon the employee’s retirement)
- Base the monthly benefit amount on factors like salary or length of service. For instance, 2% of the employee’s average salary for each of the last 5 years of service.
Like other qualified retirement plans, defined benefit plans provide tax incentives to employers and participating employees. These plans are usually funded entirely by the employer. However, employees can be required to make contributions or contribute voluntarily.
The funds in traditionally defined benefit plans are typically federally insured through the Pension Benefit Guaranty Corporation.
What employers and employees like about these plans
- Defined benefit plans enable businesses to contribute, and subsequently deduct, more annually than defined contribution plans (such as 401(k) plans).
- For 2022, the IRS hard dollar limit for defined benefit plan contributions is $245,000.
- Benefits are not contingent on asset returns.
Disappointments that some have experienced
- Defined benefit plans are more complex to administer than other types of retirement plans. This makes them more expensive to set up and maintain.
- The IRS has minimum participation and contribution rules for defined benefit plans.
- Failure to meet the minimum participation and contribution requirements may lead to penalties.
If you offer a defined benefit plan
- You can sponsor other types of retirement plans
- Your company can be of any size
- You must file a Form 5500 and Schedule SB annually
- Companies cannot retroactively reduce benefits
- You must have an enrolled actuary who handles certain duties, such as determining funding levels and signing the Schedule SB
The importance of defined benefit plans to HR leaders and small businesses
As with most things, defined benefit pension plans have pros and cons. HR leaders must examine the upsides and downsides when deciding whether to offer a defined benefit plan. Additionally, HR leaders must know the legal requirements under the Internal Revenue Code and the Employee Retirement Income Security Act.
Most employers today offer a defined contribution plan — for example, 401(k) — instead of a defined benefit plan. Small businesses, in particular, might not be equipped to handle the heavy responsibilities and costs of a defined benefit plan. That said, a defined benefit plan might be ideal for some businesses, such as those with very few employees.
The history of defined benefit plans
Defined benefits plans were first introduced in the United States during the Revolutionary War, which lasted from 1775 – 1783. They materialized as a result of the government promising pension benefits to veterans of the Revolutionary War.
Over time, defined benefit plans grew in popularity, with employers independently funding the programs. Defined benefit plans began losing momentum when defined contribution plans started to gain steam. Unlike defined benefit plans, defined contribution plans place the responsibility of saving for retirement mostly on employees.
Other terms similar to defined benefit plans that can assist you
- Alternatives to 401(k) plans: These plans offer retirement savings options to individuals who do not have a 401(k) plan at work. Alternatives include traditional Individual Retirement Accounts (IRAs) and Roth IRAs.
- Defined contribution plans: A retirement plan that enables the employer, the employee, or both, to contribute to the employee’s account. These include 401(k), 403(b), and profit-sharing plans.
- Employee retirement planning: A process that helps employees strengthen their readiness for retirement. Employers can assist by offering a job-based retirement plan.
- Retirement savings options. The different types of plans that allow people to supplement their social security benefits and to save for their retirements, such as defined employee contribution plans and employer contribution plans, include IRAs, solo 401(k) plans, and traditional pension plans.
- 401(k) eligibility: The criteria a person must meet in order to participate in a 401(k) plan involve factors such as age and length of service requirements.
- Retirement plan vendors: Third-party entities that provide retirement plan services — e.g., financial advisors, plan providers, recordkeepers, and plan administrators.
Summary of defined benefit plans
Defined benefit pension plans are qualified retirement plans that let employers provide a fixed, pre-established amount at retirement. For example, employers can pay $200 per month or tie the monthly benefit amount to salary or length of employment.
Defined benefit plans have their strong points, including a much higher annual contribution limit. But they are more complicated and costly to establish and manage than other types of retirement plans. For these reasons, most employers choose to offer defined contribution plans instead of defined benefit plans.
HR leaders and small businesses should carefully consider the advantages and disadvantages of defined benefit plans before adopting them.
Similar Glossary definitions you must know
Defined contribution plan: A retirement plan in which the employer, the employee, or both, contribute to the employee’s account. Includes 401(k), 403(b), and profit-sharing plans.
Form 5500 Filing: Covered employers with applicable health and welfare plans and retirement plans must file Form 5500 annually to satisfy ERISA’s reporting requirements.
Individual Retirement Account (IRA): An investment account that lets individuals save for retirement. An IRA can be traditional, meaning pretax, or Roth, meaning after-tax.
Non-Qualified Plan: A retirement plan that is not subject to ERISA. Nonqualified plans are often deferred compensation arrangements, where the employer agrees to delay paying a portion of an employee’s compensation until a later date.