A Defined Benefit (DB) plan is designed to ensure that participants in the plan have enough money to rely on once they retire. The retirement age in a DB plan is assumed to be between 62 and 65 years of age.
Each year, a new contribution range will be calculated for your DB plan. These calculations rely on the number of years plan participants have left until retirement. Plans with older participants will have larger contributions because the employees are closer to retirement and therefore have less time to contribute to the plan. A plan with younger participants will have smaller contributions because the employer has more years to fund the plan.
In addition, DB plans assume that assets will accrue at a fixed interest rate each year. Therefore the success of plan assets will also factor into each year’s contribution range. For example, assume a plan expects a 5% rate of return on assets. At the beginning of a given plan year, the plan has $100,000 in assets and the end monetary goal is to have $1,000,000 for the employer by the time he retires.
The assets do well and have a 25% rate of return. Because the rate of return was much higher than expected, the assets in the plan have a higher value than anticipated. Consequently, the next year’s contribution range will be reduced to accommodate the unexpected increase in asset value. In sum, a large return on assets will result in a smaller contribution the following year.
The assets suffer a 20% loss. Because the rate of return is much lower than expected, the assets in the plan will also be lower than expected. As a result, the plan will need to compensate for the loss by increasing the contribution range in the following plan year.
A major step in creating a DB plan is determining the percentage of compensation each participant should receive upon retirement. While you can not discriminate among individual participants, an employer may decide that all workers with a certain job description will get x% of their compensation while workers of another job description will get y% of their compensation. This setup is referred to as a tiered benefit formula.
Plan trustees have a say as to what type of formula(s) they would like to utilize in their plan. Broadly speaking, the higher the formula, the greater the contribution range.