Traditional defined benefit plans, structured to provide a lifelong pension, have become rare in the private sector. They are still the norm for public sector employers; some large companies continue to offer plans.

Ironically, these plans might be a good fit for extremely small companies. A possible prospect could be a business or professional practice with one or two principals who are, perhaps, 5–10 years from retirement with a few employees who are younger and modestly compensated.

Key difference

Most private sector retirement plans today are defined contribution plans. That is, the amounts that can be contributed to the plan are set by law, with a maximum of $60,000 (counting employee and employer inputs) in 2017 or $54,000 for those under age 50. The amount of the eventual retirement fund will depend on how much is contributed and how well the selected investments perform.

Defined benefit plans, as the name indicates, operate by setting a target benefit: the amount of a pension a given employee will receive in retirement. That benefit is determined by an employee’s age, compensation, and years of service with the company. Such plans might permit annual contributions more than $120,000 to the principal’s account, in certain circumstances. With few years to retirement, it will be necessary to build an adequate fund quickly, with large annual cash flows into the plan.

Those contributions can be tax-deductible for the employer and not taxable to the employee until money is received in retirement. Much smaller amounts might have to be contributed to the accounts of younger employees, who have many years to build up a retirement fund. In addition, the money in the principal’s account eventually may be rolled over into an IRA, tax-free, for ongoing control over investment decisions and distributions.

Note: Even if your company already has a defined contribution plan such as a 401(k), it may be able to establish a defined benefit plan as well.

Proceed with care

Before jumping into a defined benefit plan, business owners should consider the drawbacks. These plans can be extremely expensive to administer. You must hire an actuary or a third-party administrator to calculate how much to contribute annually. Furthermore, your company must continue to make the required payments to the plan, even in a down year, and underfunding might trigger IRS penalties. Other rules and regulations apply to defined benefit plans.

In addition, some defined benefit plans may be structured so that employees who do not work for a specified number of years forfeit their benefits. This can create incentives for the company’s principals to hire short-term workers. Hiring individuals who become long-term employees probably will be better for the firm, in terms of business results, but these workers eventually may be entitled to large payouts from the plan.

Overall, there is more to a small-company defined benefit plan than large tax-deductible contributions for business owners. If you think such a plan could work for you, our office can review the numbers with you and explain the requirements that your company would face.