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Defined-benefit plans
Instead of offering a defined-contribution plan, you may decide to offer a traditional pension plan that pays a fixed or formula-based amount to plan participants. Benefit amounts are determined by the participant's salary history and years of service. A traditional pension may, or may not, include a cost-of-living adjustment (COLA).
The PBGC, a government agency, guarantees traditional pension plans that cover nearly 44 million private-sector employees. These traditional pension plans are called defined-benefit retirement plans. According to the PBGC, the maximum guaranteed monthly amount for pensions in 2007 is $4,125 for workers who retire at age 65. The maximum guaranteed yearly amount is $49,500 for workers who retire at age 65.
The PBGC's primary pension-insurance program is aimed at protecting the pension plans of an estimated 30,330 single-employer plans (Another program, which covers multi-employer plans, is much smaller and relies on loans to plan sponsors that cannot pay their pension obligations.) The single-employer insurance program relies on the PBGC to step in as plan trustee if the plan sponsor becomes unable to pay.
To pay for insurance coverage, plan sponsors pay insurance premiums to the PBGC. The 2007 premium for the single-employer plan is $30 per year per plan participant.
Defined-benefit plans are funded entirely by your contributions. Unlike a defined-contribution plan, employees do not contribute to their own retirement accounts. Also, funding a defined-benefit plan is not made to individuals' accounts the way defined-contribution plans are.
You should obtain professional actuarial advice to determine the level of benefits you want to provide employees. Qualified defined-benefit plans require you to make a minimum funding contribution, as well as quarterly payments to keep on track with these funding requirements. You should refer to section 412 of the U.S. tax code to help you calculate minimum funding requirements.
For 2007, the limit to a defined-benefit qualified plan is the lesser of $180,000 or 100% of the employee's average compensation over a consecutive three-year period that spans his or her highest compensation.
If you sponsor a defined-benefit plan, plan beneficiaries will have to vest. The two main types of vesting are cliff vesting and graded vesting. As the plan sponsor, you have the option of making a lump-sum payment to the plan participant if the value of the pension is $5,000 or less.
Similar to a defined-contribution plan, a defined-benefit plan requires a plan administrator to manage your pension plan. The plan administrator may be you or a third party that you hire. The PBGC requires the plan administrator to provide an annual report and individual benefit statement, as well as notify participants if the plan is considered to be under-funded.
While you can generally cancel a defined-contribution plan at any time, a PBGC-insured defined-benefit plan can only be cancelled under certain circumstances. For more information on setting up defined-benefit pension plans, see the Web sites of the (PBGC) and the U.S. Department of Labor (DOL).
The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax adviser.
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