Should the employer promise a set level of benefits or a set level of contributions?

A pension or annuity plan that promises a specified retirement benefit (for example, 1 percent of compensation for each year of service or 30 percent of average annual compensation) is called a defined benefit plan. In defined benefit plans, an employee can look forward to a fixed or determinable pension upon retirement.

A defined contribution plan is different because it does not guarantee employees a fixed level of benefits upon retirement. Instead, the employer agrees to contribute a particular amount to participants' individual accounts, which may rise or fall depending on investment activity and other factors. Types of defined contribution plans include profit-sharing plans, money-purchase pension plans (like 401(k) plans), and stock bonus plans, including employee stock ownership plans (ESOPs).

Rising employer costs to maintain defined benefit pension plans, coupled with regulatory changes and employee savings preferences, have led to a shift in investment emphasis from defined benefit plans to defined contribution vehicles such as 401(k) and profit-sharing plans. However, there is a concern that plans funded on a contribution basis may provide inadequate retirement benefits.

Who is favored under a defined benefit plan? A defined benefit plan favors employees who are:

• older;

• long-service;

• higher-paid;

• quit after long service; and

• survive to retire from the service of the employer.

Who is favored under a defined contribution plan? Conversely, defined contribution plan favors employees who are:

• younger;

• short-service;

• lower-paid;

• quit after medium lengths of service; and

• die in service before retirement.

Defined benefit plans are subject to the extensive funding requirements of ERISA [see What is ERISA and how does it affect retirement plans? at ¶47,110 ]. So are defined contribution plans, but the requirements are substantially easier to meet for these plans. The funding rules do not cover profit-sharing plans.

Funding rules. The Pension Protection Act of 2006 changed the funding rules, beginning with the 2008 plan year. The funding standard account mechanism and the two-tiered funding system was replaced with a single funding method. An employer maintaining a single-employer defined benefit plan that is not 100-percent funded is not required to make a deficit reduction contribution, but is required to make a minimum contribution that is based on the plan's assets (reduced by credit balances), funding target, and target normal cost and that is sufficient to amortize unfunded plan liabilities over a period of seven years. Unlike previous law, which required employers to fund up to 90 percent of a plan's total liabilities, the funding target is now increased to 100 percent of target or current liabilities.

How do defined benefit and defined contribution plans compare? The following briefly highlights the essential differences between defined benefit pension plans and defined contribution plans, including profit-sharing plans, in terms of contributions and payments:

Employer contributions: In a defined benefit plan, the employer contributions necessary to provide the promised benefits are determined on an actuarial basis. The highest annual benefit that can be paid is the lesser of:

1. $195,000 in 2009, which may be adjusted by $5,000 increments in later years for inflation, or

2. 100 percent of the participant's average compensation for the highest three consecutive calendar years during which he or she was an active participant.

In defined contribution and deferred profit-sharing plans, amounts are determined as a percentage of compensation, as well as a percentage of profits in the case of profit-sharing plans. The annual dollar limits for contributions that can be made to each participant's account are the lesser of:

1. $49,000 in 2009, which may be adjusted by $1,000 increments in later years for inflation, or

2. 100 percent of compensation.

Forfeiture of benefits: In defined benefit plans, forfeitures are used to reduce the employer's costs for pensions under the plan and are not credited to individual employee accounts, nor do the employees benefit from such forfeitures in any way.

In defined contribution and deferred profit-sharing plans, forfeitures are not credited to the employer but are distributed among the current participants in a deferred profit-sharing plan. Forfeitures arise because of terminations of employment and sometimes because of the death of a member of the plan before that member has had sufficient length of service to qualify under the plan for a full vested right to the accumulations in his or her account.

In the profit-sharing plan, the amounts forfeited by termination of employment are reallocated each year among the remaining members of the plan, usually in proportion to their salaries, as if the forfeitures were additional contributions made by the employer. In some instances, forfeitures are reallocated in proportion to the account balances of the participants; however, there is a possibility of discrimination in this regard. As a result, most profit-sharing plans reallocate forfeitures by the same method used in the plans to allocate current employer contributions.

ERISA absolutely prohibits the forfeiture of an employee's vested benefits derived from his or her own contributions.

Payment of benefits: In defined benefit plans, the benefits are usually paid at normal retirement date or at an earlier date in the event of death, disability or termination of employment. The normal retirement date is defined in the plan as the date on which the employee may retire with his full benefits under the plan. The employee would normally receive retirement income starting at that date.

Upon termination of an employee's services, vested and/or unvested benefits can be involuntarily cashed out by the plan if the present value of the benefits is less than $5,000.

In defined contribution and deferred profit-sharing plans, the employee may receive a lump-sum equivalent to the total value of the account as of the normal retirement date. The lump sum could be paid earlier in case of death, disability or termination of employment. The involuntary cash-out rule is also applicable to profit-sharing plans.

Survivor benefits: Both ERISA and the Internal Revenue Code require a defined benefit plan or a money purchase plan to provide automatic survivor benefits.