Everybody wants a pension, but nobody wants to pay for it.
Old-fashioned pensions, known as defined benefit pension plans, have fallen out of favor as an employee benefit because employers can’t over the long haul predict the often-staggering costs. They are especially daunting for small businesses.
But defined benefit pensions are probably the best plans for a secure retirements. So beginning Jan. 1, Congress has approved a new way to encourage small businesses – between 2 and 500 employees – to reconsider defined benefit pensions. This new wrinkle is called a Defined Benefit (k) or DB(k) and it’s a hybrid of a defined contribution 401(k) and a defined benefit plan.
In creating a DB(k) Congress has tried to mitigate some of the reasons why small companies have avoided existing pension plans. While DB(k)s requires contributions from both the employer and the employee, they promise to be much simpler and cheaper to administrate than traditional defined benefit pensions. Their payout is generally lower than your father got, so the cost to the employer should be less. And they exempt companies from most of the rules that prevent highly compensated employees from participating fully in 401(k) plans.
Despite the fact that these DB(k)s were part of the 2006 Pension Protection Act, the IRS isn’t ready to opine on all the ins and outs, so it will be later in 2010 before they are widely available.
These plans combine a 401(k)-like contribution with an employer match. The defined benefit part of the plan must provide a benefit equal to 1 percent of the final average pay times years of service up to a maximum of 20 percent of final pay.
The 401(k) part of the plan requires automatic enrollment with an employee deferral of 4 percent of compensation.
Matching contributions for highly compensated employees can’t exceed the matching contribution rate for non-highly compensated employees, but otherwise there are few restrictions that prevent the execs from putting away a significant amount of money.
Employees must be immediately vested in their 401(k) accounts, and automatic deferral must equal between 3 percent and 10 percent of compensation with at least:
- 3 percent in the first year of participation
- 4 percent in the second year of participation
- 5 percent in the third year of participation
- 6 percent, but not more than 10 percent, in any subsequent years of participation
The DB portion must be vested after no more than two years. There are two ways employers can calculate their contributions:
- Matching must equal 100 percent of elective deferrals up to 1 percent of compensation, plus 50 percent of elective deferrals of more than 1 percent up to 6 percent of compensation.
- Or automatic employer contributions must equal 3 percent of compensation.
DB(k)s promise to be paperwork light. The employer only has to file one plan document and one IRS Form 5500 – a huge improvement over the paperwork generally associated with defined benefit plans.
Pension plan experts are lukewarm about DB(k)s.
“What this is really going to be useful for are small employers with fewer than 10 employees – and it will be particularly useful for groups like doctors practices and law offices where you have owners with lots of tenure and younger and lower-paid employees without quite as much tenure,” says Steven Dimitriou, a managing partner with Mayflower Advisors in Boston.
“But my guess is that for the bulk of businesses – 90 percent – there will be better plan designs,” he added.
Likewise, attorney Ary Rosenbaum, an associate with Meyer Suozzi English & Klein on long Island, New York, says while DB(k)s will probably be a lot cheaper to set up and administrate than some other retirement plan alternatives for small employers, DB(k)s – like other defined benefit plans – require a company to make what can be an outsize financial commitment in years when cash flow is bad.