In planning for retirement, one of the most important questions is what is a defined benefit plan, and whether it might offer superior advantages over other retirement plans. For business owners, high‑earning professionals, retirees, and those seeking predictable retirement income, a defined benefit plan can be a powerful tool. In this guide we explain what defined benefit pension plans are, how they differ from defined contribution plan or cash balance plans, what factors make them right or not right, and how to structure them so that you maximize benefit while complying with IRS and other rules.
What Is a Defined Benefit Plan
A defined benefit plan, often known as a traditional pension plan or db plan, is a retirement benefit plan where the employer promises a specific, defined retirement benefit to plan participants. That promised benefit is often expressed as a monthly benefit for life, based on an exact formula involving years of service, final salary or average salary, and possibly other factors. Unlike defined contribution plans (dc plan) arrangements, in a defined benefit plan the benefit amount does not depend on investment performance, once the benefit formula is set, but rather the employer bears the investment risk, funding levels, and actuarial assumptions.
Under a defined benefit pension plan, plan participants know in advance the benefit amount they will receive when they retire, assuming the required years of service and other eligibility factors are met. The exact dollar amount or the formula is stated up front, for example “2% of final salary per year of service.” That very structure is what distinguishes defined benefit from defined contribution plan types where individual retirement accounts grow by contributions plus investment returns but without a guarantee of a fixed monthly benefit.
Key Features of Defined Benefit Plans
Benefit Formula, Years of Service, Salary, Multiplier
In a defined benefit pension plan the retirement benefit is determined by a formula, which typically is something like:
Benefit amount = Years of service × Average salary (or final salary) × Multiplier
For example if you have 20 years of service, an average salary of $200,000, and a multiplier of 2%, you might receive a retirement benefit of $80,000 per year as a monthly benefit starting at retirement.
The value of years of service is central, because the more service you have the greater the promised benefit. Your employer must track service, salary or compensation, vesting, and eligibility. The employee's pay is a key component in this calculation.
Employer, Employee Contributions, and Funding Levels
With a defined benefit plan, the contributions are generally made by the employer, though sometimes employee contributions are allowed depending on plan design and legal requirements. The employer must maintain proper funding levels, based on actuarial valuations. The Internal Revenue Service (IRS) and ERISA set rules about required contributions and minimum funding so that the promised benefit is sustainable.
Under IRS guidance, a defined benefit plan is a retirement plan that provides a fixed benefit based on a formula, not just based on contributions plus investment outcomes. The funds are invested and managed by the plan sponsor, not by individual participants. The employer is responsible for ensuring that there are enough funds to meet the promised benefit even if investment returns are poor.
Payout Options, Lump Sum, Monthly Benefit, Survivors
At retirement or at termination (depending on the plan), participants often have options among payout options. Typically the retirement benefit will be paid as a monthly benefit for life. Some plans also allow a lump sum distribution, possibly rolled into individual retirement accounts (IRAs) or other vehicle. Survivor benefits (for surviving spouse or other beneficiary) are common. Defined benefit plans often guarantee a lifetime retirement income, which is an important contrast to defined contribution plan options where income depends on remaining balance and investment returns.
Defined Benefit Pension Plans vs Other Retirement Plans
Defined Benefit Plans vs Defined Contribution Plan
Other retirement plans like a 401(k) or profit‑sharing are defined contribution plan forms, often called dc plan, where contributions are made by employer, employee, or both, into an individual account, and the retirement value depends on contributions plus investment gains or losses. A defined contribution plan gives more flexibility and lower cost of administration, but does not guarantee a fixed retirement benefit. Defined benefit plans guarantee a benefit, but come with higher cost, regulatory compliance, and funding obligations.
Cash Balance Plans
A cash balance plan defines the promised benefit in terms more characteristic of defined contribution plan style. Participants have a stated account balance (hypothetical account) that grows via pay credits and interest credits. At retirement or termination, the accumulation may either be paid as a lump sum or converted into a monthly benefit. Because of that hybrid nature, cash balance plans often appeal to small businesses, professional firms, and owners who want higher contributions with simpler communication to employees.
Examples to Illustrate
Suppose you are a business owner age 55, with 30 years of service, average salary of $250,000, and a traditional defined benefit formula that pays 1.8% per year of service. Your benefit would be:
30 years × $250,000 × 1.8% = $135,000 annually, paid as monthly benefit (i.e. about $11,250/month for life).
Alternatively, under a cash balance plan version, your benefit might be expressed via a hypothetical account that grows each year via a percentage of your salary (say 8%) plus an interest credit (say 4%), leading to an accumulated account balance that can be paid as lump sum or converted into a monthly benefit. The difference is in how benefit is expressed, but the promised benefit (lifetime income or lump sum equivalent) is still guaranteed under defined benefit pension rules.
Who Should Consider a Defined Benefit Plan
Defined benefit plans are best for those who:
- Have steady and predictable cash flow such as profitable small businesses or professional firms
- Are high earners who have already maximized contributions under defined contribution plan limits
- Are older, often age 50 or above, who want to “catch up” on retirement savings before retiring
- Want more predictable retirement income rather than depending solely on markets and investment risk, including reliance on social security benefits
They are less suitable for those with unpredictable income, young businesses with erratic profits, or those unwilling to commit to long‑term contributions or manage regulatory and actuarial complexity.
Rules, Limits, and Regulatory Considerations
Internal Revenue Service Rules, IRS, and Compensation Limits
A defined benefit plan must comply with IRS rules, including compensation limits for calculating benefit. For example compensation used in benefit formula is capped at IRS limit (Code §401(a)(17)), which is subject to annual adjustment. Plan designs like cash balance plans also must follow IRS regulations on interest crediting, lump sum calculations, and nondiscrimination.
Pension Benefit Guaranty Corporation
Defined benefit pension plans, including cash balance plans, are insured by the Pension Benefit Guaranty Corporation for eligible plans. If the employer plan fails or is terminated and underfunded, PBGC steps in to pay benefits up to statutory limits. This is an important protection for plan participants.
Vesting, Eligibility, Years of Service
Plan participants must satisfy certain years of service and be eligible under the plan’s rules to receive promised benefit. Vesting periods are required by law, sometimes three to seven years. The benefit plan may also set minimum age or length of employment. Years of service and employee’s salary are core inputs to the benefit formula. The IRS ensures that these rules are applied fairly.
Benefit Amounts, Tax Treatment, Distributions
Retirement benefit under defined benefit plan is taxed as ordinary income when paid out. If plan participant takes lump sum, that distribution may be rolled into individual retirement accounts or other retirement savings vehicles if permitted. Lump sum options are available in many defined benefit pension plans including cash balance plans. Monthly benefit is often preferred for its guarantee and lifetime income. Other retirement plans like defined contribution plan do not usually offer guaranteed monthly benefits.
Pros and Cons of Defined Benefit Plan
Advantages
- Guaranteed retirement income for life, which means more predictable retirement benefit, less exposure to market volatility
- Higher contribution potential, enabling business owners and high income employees to defer more than under defined contribution plan limits
- Powerful tax advantages: contributions typically deductible to employer, growth tax deferred until retirement, benefits taxed when paid
Disadvantages and Risks
- Funding obligation, actuarial work, regulatory compliance add cost and complexity
- Employer bears risk from investment shortfalls, wrong assumptions, longevity risk
- Less flexibility than defined contribution plan for employees to control investments or contributions
- Lump sum option may expose recipient to investment risk once invested elsewhere
How to Setup a Defined Benefit Plan
Plan Design and Actuarial Work
To establish a defined benefit pension plan or a cash balance plan, you need to engage an actuarial firm, define benefit formula, vesting schedule, payout options, eligibility, years of service requirements. The plan must define how employee contributions (if any), employer contributions, salary/compensation used, final salary or average salary, interest credits (for cash balance), or multiplier will work.
Administrative and Regulatory Filings
Annual filings (Form 5500, Schedule SB for defined benefit plans), actuarial valuations, necessary disclosures, compliance with ERISA, and ensuring PBGC insurance when required. Must follow IRS rules on compensation limits, nondiscrimination, benefit amount maximums.
Matching with Other Retirement Plans
Many business owners combine a defined benefit plan with other retirement plans such as 401(k) (a defined contribution plan) or profit sharing to maximize overall retirement savings. Layering these can help maximize tax deductions, smooth contributions, and balance risk and flexibility.
Example Scenario
You are a business owner age 60, you have 25 years of service in your business, your final salary (or average salary, depending on plan formula) is $300,000, you choose a formula multiplier of 2.5%. Your promised benefit is:
25 × $300,000 × 2.5% = $187,500/year for life, with monthly benefit payments. If plan allows, you may elect a lump sum that actuarially equals present value of that benefit. If you add a cash balance plan component in addition to your 401(k), you may boost retirement savings further, reduce taxable income now, and still preserve retirement benefit predictability.
Frequently Asked What Is a Defined Benefit Plan Questions
Is a defined benefit plan better than a 401(k) defined contribution plan?
It depends on your priorities. If you value guaranteed retirement benefit, predictable monthly benefit payments, and have sufficient income, a defined benefit plan often outperforms over long horizon. If you want flexibility, control of investments, or less risk and cost, a 401(k) or other defined contribution plan may be better.
How much can I contribute to a defined benefit pension plan or cash balance plan?
Contribution limits depend on age, salary, years of service, benefit formula, IRS rules, and funding levels. Older high earners often can contribute significantly more under a defined benefit plan than under defined contribution plan limits.
What happens if the plan is underfunded?
The employer must make up shortfalls. Penalties may apply. PBGC may step in for certain plans, but only up to statutory limits. Regulatory oversight demands sufficient funding.
Can I roll over a lump sum distribution to an IRA or other retirement savings?
Yes, in many cases a lump sum distribution option exists. If offered, you may roll over into individual retirement accounts or other eligible retirement plan. Check plan documents carefully.
What is the role of Pension Benefit Guaranty Corporation?
PBGC insures certain defined benefit pension plans. In case plan sponsor fails or terminates an underfunded plan, PBGC ensures participants receive promised benefits within legal limits.
How are defined benefit plan payouts taxed?
Retirement income from a defined benefit plan is taxed as ordinary income when paid. If you take a lump sum, you pay taxes on the distribution, though rolling over may defer tax. Benefit paid monthly to life or via lump sum carries these tax implications.
Final Thoughts
Defined benefit plans offer a strong path to achieving reliable retirement income, especially for those who can commit to consistent employer contributions, manage funding levels, and want a stable promised retirement benefit rather than depending on market luck. If you fit the profile of a high earner or business owner, or want to supplement your existing retirement savings with benefit‑rich pension plans, you should explore whether a defined benefit plan or cash balance plan could make sense. At Towerpoint Wealth we help clients evaluate other retirement plans side by side with defined benefit pension plans, weigh tax and funding implications, and build customized retirement savings strategies that aim for predictable retirement income when you retire, while preserving flexibility and minimizing risk.
If you would like help reviewing your retirement plan options including defined benefit plan, cash balance plans, or defined contribution plan design, contact our team to schedule a consultation.
