Jul 10, 2009


A defined-contribution plan is much simpler than a defined-benefit plan. In a defined-contribution plan, the plan specifies the amount that the employer will contribute to the plan. There are two basic types of contribution formulas for defined-contribution pension plans—the money-purchase formula and the target-benefit formula. For a money-purchase formula, the annual employer contribution is usually a stated percentage of each employee's compensation—for example, 6 percent of compensation. The target-benefit formula uses an actuarial approach, providing larger contribution percentages for older plan entrants.

The following advantages have been identified for defined-contribution plans (including both pension and profit-sharing types) over defined-benefit plans:

  • Defined-contribution plans with their individual, periodically reported, and valued employee accounts are easier for the employee to understand and appreciate as a valuable benefit.
  • Administration and government regulations are generally simpler for defined-contribution plans. For example, Pension Benefit Guaranty Corporation (PBGA) coverage and reporting requirements do not apply to defined-contribution plans and ongoing actuarial services are not required for defined-contribution plans.
  • Defined-contribution plans fit the nature of today's work force, which experiences frequent job-changing, thereby putting a premium on a portable benefit that increases steadily from the first day of employment. Few employees enjoy the luxury of a 40-year career with the same employer, which typically provides the best result for defined-benefit plan participants.

In terms of the number of plans, defined-contribution plans—including profit-sharing and pension plans—constitute about 70 percent of all qualified plans. However, if a comparison is made on the basis of employees covered under qualified plans, the result is the opposite—about 60 percent of such employees are in defined-benefit plans. This indicates, not surprisingly, that defined-benefit plans tend to cover larger groups, although defined-benefit plans are often used for smaller groups as well.

Money-Purchase Formulas
In a money-purchase plan, as in all defined-contribution plans, there is an individual account for each employee. The amount of the benefit at retirement is equal to the employee's account balance at the retirement date or at a valuation date near the time of the retirement date. The plan may provide for payment of the benefit in a lump sum; a variety of payment options, including annuity benefits, may also be made available. The accounts of all employees are usually commingled for investment purposes; each account is kept separate administratively, so that the account increases and decreases in accordance with the investment performance of the fund. Thus, the benefit available at retirement cannot be predicted exactly. Investment risk lies with the employee. If the employee's account is less than anticipated, the employer is not required to make additional contributions.

Target Plans
From a planning point of view, the target plan is a hybrid of the defined-contribution and defined-benefit approaches. Under a target plan, the employer chooses a target level of retirement benefit using a benefit-formula approach similar to that used in designing a defined-benefit plan.

For example, the target level might be some percentage of each participant's final-average compensation. At the plan's inception, an actuarial calculation is made of the level annual contribution amount (for each participant) that would be required to fully fund this benefit at the participant's normal retirement date. These level amounts are then actually contributed by the employer to the plan each year. Unlike a defined-benefit plan, however, there is no change in the level contribution amount if actual investment return or mortality varies from the assumptions used in determining the initial contribution level, unless the plan is actually amended. Therefore, at retirement, the amount actually available may be more or less than anticipated. The plan has individual accounts for each participant, and unlike a defined-benefit plan, each employee's benefit is limited to the amount actually in his or her individual account.

Because a target plan is a defined-contribution plan, it is subject to the Section 415 limits applicable to defined-contribution plans. Under this limit the annual addition to each participant's account cannot exceed the lesser of 25 percent of compensation or $30,000 (dollar figure subject to indexing for inflation; $30,000 in 2000). For some older employees, this limit might prevent making a large enough contribution to fund the target benefit. For example, if an employee enters the plan at age 60 and earns $50,000, the target formula might require a contribution of $15,000 annually, but the actual contribution would be limited to $12,500 (25 percent of $50,000). This disadvantage of a target plan does not apply to a defined-benefit plan, for which the applicable Section 415 limit is not based on the annual contribution.

Target plans are an example of a more general type of benefit/contribution formula design based on what is known as cross-testing. A cross-tested defined-contribution formula is tested for discrimination in favor of the highly compensated by looking at employees' projected benefits at retirement (assuming they continue in employment until retirement age) rather than testing the contribution formula directly. Cross-testing in connection with profit-sharing plans, specifically age-weighted profit-sharing formulas. Currently, employers considering this approach in benefit design are likely to be more interested in age-weighted profit-sharing plans than in target pension plans, because profit-sharing plans have more flexibility in annual contribution levels. Target plans, like all pension plans, require that the employer commit to a fixed annual contribution obligation.


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