Dodd S. Griffith

Published on : 2011-05-05

Despite recession setback, companies still choose 401(k) plans.

Secure retirement. For too many people, this statement is an oxymoron. And it looks like changing that situation will fall squarely on the shoulders of employees — many of whom are not prepared — as defined benefit plans, or pensions, continue to decline in popularity.

The best prospects for new pension programs come from closely held professional organizations like medical practices, engineering firms or the like that have regular, non-volatile cash flow over many years and many owners/principals nearing retirement age. Employers that choose to invest in a defined benefit plan must determine what risk they are willing to take and what their expected obligations will be over time, as defaulting on those promises is costly.

For many workers today, it’s hard to imagine a time when retirement money wasn’t socked away into a 401(k) with matching funds from an employer. But it wasn’t that long ago — about 30 years — that defined benefit plans, or pensions, were the primary mode of retirement savings. Then, about 62 percent of workers receiving retirement benefits received them solely from defined benefit pension plans. Today 63 percent of people with benefits rely solely on 401(k) plans.

This all seemed great during the stock market booms that occurred over the 20-year period ending in 2007. The broad upward trends in the stock market made everyone feel like they were savvy investors, and that there was no need for professional money management. Then came the great recession of 2008, where equities declined by 42 percent during a one year period, and 401(k) plan assets declined by $1.1 trillion dollars. The typical 401(k) participant nearing retirement had two-thirds of his or her assets invested in stocks – and median holdings fell 30 percent in 2008. Suddenly, stodgy old traditional pensions that paid a defined benefit did not sound so bad to many employees.

While many employers remain leery of taking on the burdens of a defined benefit pension plan, the potential advantages of traditional pension plans should not be discounted. A pension plan can provide an employer with a competitive advantage in hiring key employees and retaining current employees. A pension plan can also provide tax advantages to the employer, and can be particularly beneficial to an employer with a significant number of older employees for whom the employer wishes to maximize retirement benefits.

Defining the Benefit

A defined benefit pension plan provides a fixed benefit at retirement that is generally determined by the employee’s years of service and compensation. The plan guarantees the employee a fixed sum, payable monthly or annually, for a fixed period after retirement. The benefit can be payable for a term of years, for life, or even over the life of the employee and his or her spouse. In addition, a defined benefit pension plan can be set up to give the employee the option to take the retirement benefit in many ways, such as lump sum rather than in installments.

If an employer adopts a defined benefit pension plan, the employer is committing to fund the plan until such time as it is permitted by the U.S. Department of Labor to freeze or terminate it. The Department of Labor generally does not permit plan terminations other than in cases of bankruptcy. Consequently, an employer should only establish a defined benefit pension plan if it expects to be able to sustain a series of regular, annual, required contributions to the plan and its beneficiaries.

If an employer fails to meet the minimum funding requirement in any year, significant penalties may be assessed (though funding deadline waivers may be granted if requested in a timely manner). An employer generally is subject to an excise tax if it fails to make minimum required contributions and fails to obtain a waiver from the Internal Revenue Service. The excise tax is 10 percent of the aggregate unpaid minimum required contributions for all plan years remaining unpaid as of the end of any plan year. In addition, a tax of 100 percent may be imposed if any unpaid minimum required contributions remain unpaid after a certain period.

For mature businesses that have steady and predictable cash flows, defined benefit pension plans can provide some major advantages over defined contribution plans like 401(k)s. If the owners and key employees of a business are older and nearing retirement, a defined benefit pension plan will often provide the employer with the greatest current deduction from income, and the greatest retirement benefit. This is because an employer is permitted to provide a far greater benefit under a defined benefit pension plan than under a defined contribution plan. For 2011, 401(k) plans can contribute only $49,000 per year per employee. In contrast, for 2011, a pension plan can be funded to provide an annual retirement benefit of $195,000.

In addition, defined benefit pension plans can be designed to give credit for service with another employer. Credit for past service may be given if it is done in a way that does not discriminate in favor of highly compensated employees. A special rule allows up to five years of past service credit without being considered discriminatory. That means a defined benefit pension plan can be designed and used to attract older key employees to an employer, based on credit for time worked with a competitor.

Pension vs. 401(k)

There are some notable differences between defined benefit pension plans and defined benefit contribution plans such as 401(k) plans. The biggest difference for the employer is the annual funding obligation associated with defined benefit pension plans. The biggest difference for employees is who bears the risk of loss – in the case of pensions, the employer – if the stock market tanks as the employee nears retirement. However, there are some other differences worth noting.

• Matching requirements: Employees often forego participation in 401(k) plans because they don’t think they can afford to contribute while employer contributions to 401(k) plans are often limited to matching contributions. In contrast, employees are generally not required to contribute to pension plans.
• Portability: Today’s more mobile workforce may see some advantages to 401(k) plans that earlier generations might have discounted. The portability of a 401(k) plan may provide a benefit to those workers who frequently change jobs over their careers. In contrast, a defined benefit pension plan is typically most advantageous to an older worker who has stayed in the same job for many years since the typical pension plan formula provides a maximum benefit based on years of service and the employee’s final salary.
• Risks: Defined benefit pension plans hold all assets in a single pooled trust from which benefits are drawn when each employee retires. Employees do not have individual accounts as part of a traditional defined benefit pension plan, and are guaranteed a payout regardless of market performance, though there are some risks as the federal government ensures them to certain limits. In 401(k) plans, employees can control where money is invested, but if the market crashes, so (in all likelihood) does their portfolio.
• Disbursement Rules: Unlike defined contribution plans, defined benefit pension plans cannot make in-service or hardship distributions to employees. However, loans may be made to employees if the plan is designed to satisfy certain tax requirements.
• Tax Advantages: If a pension plan meets the required qualification standards, then employers receive a federal corporate income tax deduction for contributions made to the plan (subject to certain limits that prevent employers from receiving tax benefits for “overfunding” a pension plan). Employees do not have to report any income until distributions are made, and earnings within the plan are accumulated on a tax-free basis. Comparable tax benefits apply to 401(k) plans, but the tax deductions for pension plans are higher as the annual contribution limits are higher.
• Determining Funding Obligations: An employer’s biggest fear related to establishing a defined benefit pension plan typically relates to the funding obligations. The plan’s funding obligations are determined annually based on the plan’s assets versus its obligations to retirees. The plan’s assets depend on both investment performance and the rate at which assets must be expended to fund obligations to retirees. It is crucial to have expert actuarial and investment advice regarding the anticipated funding obligations.

Financial performance of plan investments is important, but the actuarial assumptions used in designing a defined benefit pension plan will also have a major effect on the plan’s funding obligations and on the annual amount the employer must contribute to fund the plan. Any employer who is considering adopting a defined benefit pension plan should carefully select an actuary. Likewise, the employer should carefully review the actuarial assumptions including the annual rate of return from investment, and the demographics of the employer and its employees.

Although defined benefit pension plans provide significant potential benefits, realizing those benefits requires an employer to work carefully with an actuarial consultant, investment adviser, and legal and accounting professionals to carefully design and implement a plan that works for the employer and its employees.

Dodd S. Griffith is a shareholder and director of Gallagher, Callahan & Gartrell, P.C. in Concord. He chairs the firm¹s tax practice group and is frequently involved with the design, review and implementation of pension and benefit plans, and executive compensation plans for directors and senior executives. He can be reached at 603-545-3610 or by e-mail.

* Dodd Griffith is admitted in New Hampshire.