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).
Cash Balance Plans
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.
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 IRAs 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 IRAs. 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 $52,000 for 2014 ($53,000 for 2015).
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.