Quick answer
A defined benefit plan can make sense for a closely held business when the owner wants to save more for retirement than a 401(k) alone allows, profits are steady enough to support required annual contributions, and the employee census makes the cost of covering staff reasonable. Because the business commits to funding a promised benefit, the plan tends to suit companies that can handle that obligation in both good and lean years.
How a defined benefit plan differs from a 401(k)
A 401(k) is a defined contribution plan. The amount that goes in is set, and the retirement balance depends on contributions and investment results. A defined benefit plan works the other way around. The plan promises a benefit at retirement, often based on pay and years of service, and the employer must contribute enough to fund that promise.
An actuary calculates how much needs to go in each year based on the promised benefits, participant ages, and assumptions about investment returns. If investments fall short of those assumptions, the business may need to contribute more. If they do better, required contributions may go down.
A common variation is the cash balance plan. It is still a defined benefit plan legally, but each participant’s benefit is expressed as a hypothetical account balance that grows with pay credits and interest credits. Many owners find that easier to understand and explain to employees.
When it tends to fit
There is no single test, but certain conditions come up often when a defined benefit plan is a reasonable option:
- Consistent profits. Required contributions are a firm commitment. Businesses with predictable cash flow are better positioned to meet them.
- Owners who want to save more. Defined benefit plans can allow much larger tax-deductible contributions than a 401(k), particularly for older owners who have fewer years to fund a benefit.
- A favorable workforce profile. Plans must cover eligible employees under nondiscrimination rules. Cost depends heavily on the ages and pay of the workforce.
- A plan to stay in place for several years. These plans are generally expected to be ongoing, not set up for a single good year.
- An existing 401(k). Many businesses pair a defined benefit or cash balance plan with a 401(k) profit sharing plan to coordinate contributions.
When it may not fit
A defined benefit plan is a serious commitment, and it is not right for every business. It may be a poor fit when:
- Revenue swings widely from year to year
- The company has a large workforce relative to the owners’ share of benefits
- The owner expects to sell, close, or restructure the business soon
- The business cannot absorb higher administrative and actuarial costs
| Factor | 401(k) profit sharing plan | Defined benefit or cash balance plan |
|---|---|---|
| Who bears investment risk | Participants | Employer |
| Contribution flexibility | Employer contributions can often vary | Required annual funding set by an actuary |
| Potential contribution size | Limited by annual IRS limits | Can be larger, depending on age and pay |
| Administrative cost | Lower | Higher, including actuarial work |
| Government insurance | Not applicable | PBGC coverage may apply |
Costs, rules, and risks to weigh
Funding obligations
The business must make minimum required contributions each year. Missing them can lead to excise taxes and other consequences. Owners should plan for years when profits are lower.
Investment risk sits with the employer
Because the benefit is promised, poor investment results generally mean the company has to contribute more. How plan assets are invested, and how that strategy matches the plan’s obligations, is a central decision. The investment management page describes how APS approaches this kind of work.
PBGC coverage
Many defined benefit plans are insured by the Pension Benefit Guaranty Corporation, which charges premiums. Some plans, such as certain plans covering only owners or sponsored by some professional service employers with few participants, may not be covered. Whether a plan is covered affects cost and reporting.
Ongoing administration
Annual actuarial valuations, government filings, and participant notices are required. These plans need a team that understands both the actuarial and administrative sides.
Ending the plan
A plan can be terminated, but the benefits earned must be fully funded first. If assets fall short, the employer may need to contribute more before the plan can close.
The role of plan design and coordination
Getting value from a defined benefit plan depends on design. The benefit formula, the interaction with any 401(k) plan, eligibility rules, and investment strategy all need to work together. That usually means coordination among the plan actuary, the third-party administrator, the company’s accountant, and the investment advisor.
APS Pension & Financial Services in Melville, New York, has worked with closely held businesses on pension design, administration, and actuarial consulting for more than four decades. Steven J. Musmanno, the firm’s Chief Investment Officer, also consults on pension and qualified plan design for the firm’s actuarial and third-party administration business, and APS Investment Management provides advisory services to qualified plans including defined benefit plans. Background on the firm and its Long Island base is on the Melville, NY page.
For a broader look at how a qualified plan can support an owner’s goals, see using the company retirement plan for tax management and wealth creation.
Key takeaways
- A defined benefit plan promises a benefit, and the employer must fund it each year based on actuarial calculations.
- It often fits businesses with steady profits, owners who want to save more than a 401(k) allows, and a workforce that keeps costs manageable.
- The employer carries the investment risk, and PBGC premiums and coverage rules may apply.
- Administration and actuarial costs are higher than for a 401(k).
- Owners should review design, cost, and tax effects with an actuary, accountant, and legal advisor before adopting a plan.
Frequently asked questions
What is the difference between a defined benefit plan and a cash balance plan?
A cash balance plan is a type of defined benefit plan. Instead of a traditional pension formula, each participant’s benefit is shown as an account balance that grows with pay credits and interest credits, though the employer still bears funding responsibility.
Can a business have both a 401(k) and a defined benefit plan?
Yes. Many closely held businesses pair the two. The plans must be designed to work together and pass combined testing requirements.
What happens if the business has a bad year?
Minimum required contributions still apply. Some plans have a range of allowable contributions, but owners should plan for the possibility of funding in lean years.
Are contributions tax-deductible?
Employer contributions to a qualified defined benefit plan are generally deductible within limits. A tax advisor can confirm how this applies to a specific business.
