Defined Benefit Pension Plans

Defined benefit (DB) pension plans represent the traditional pension model where the employer promises a specific benefit at retirement based on a predetermined formula. Unlike defined contribution plans where the employee bears investment risk, in DB plans the employer assumes all investment risk and is responsible for funding the plan adequately to meet promised benefits.

Types of Defined Benefit Plans

There are two main types of defined benefit pension plans:

Traditional Defined Benefit Plans

Traditional DB plans calculate benefits using one of three formulas and pay benefits directly from a commingled trust. Participants have accrued benefits rather than individual account balances.

Cash Balance Pension Plans

Cash balance plans are a hybrid that combines features of both DB and DC plans:

• Legally classified as defined benefit plans
• Participants see a hypothetical account balance with guaranteed annual contribution rates and guaranteed earnings
• Despite the account appearance, assets remain commingled
• Requires an actuary annually (like traditional DB)
• Uses 3-year cliff vesting (more accelerated than traditional DB)
• Favors younger employees (unlike traditional DB plans)

Benefit Formulas

Traditional DB plans use one of three formulas to calculate retirement benefits:

1. Flat Amount Formula

Provides an equal dollar benefit to all participants regardless of salary or years of service.

Example: All retirees receive $1,500 per month.

2. Flat Percentage Formula

Provides a benefit equal to a percentage of salary, typically based on final average salary or career average salary.

Example: 50% of final average salary.

3. Unit Credit Formula (Most Common)

The most widely used formula, calculating benefits based on years of service multiplied by a percentage multiplied by salary:

Formula: Years of Service x Percentage x Average Salary

Example: 2% x 25 years x $100,000 average salary = $50,000 annual benefit

2025 Annual Benefit Limit

The maximum annual benefit that can be paid from a defined benefit plan under IRC Section 415(b) for 2025 is the lesser of:

• $280,000, or
• 100% of the participant's average compensation for the highest 3 consecutive years

This limit applies to the annual benefit payable at the plan's normal retirement age (typically 62-65). Benefits taken before age 62 or after age 65 require actuarial adjustments.

CFP Exam Note: The $280,000 limit is reduced by 10% for each year of plan participation less than 10, but never below 10% of the full limit.

Mandatory Funding and Actuary Requirements

DB plans have mandatory funding requirements:

• Employer must contribute enough to fund promised benefits
• An actuary must be used annually to determine required contributions
• Actuary calculates the minimum contribution based on assumptions about investment returns, mortality, turnover, and salary increases
• Funding rules were significantly modified by the Pension Protection Act (PPA) of 2006

PBGC Insurance

The Pension Benefit Guaranty Corporation (PBGC) provides insurance protection for participants in defined benefit plans:

• PBGC guarantees payment of basic pension benefits if a plan terminates without sufficient assets
• Employers pay premiums to the PBGC based on the number of participants and funding status

Exception: Professional service firms (doctors, lawyers, architects, etc.) with fewer than 25 employees are NOT covered by PBGC insurance.

QJSA and QPSA Requirements

All pension plans (including DB plans) must offer:

Qualified Joint and Survivor Annuity (QJSA)

• Default form of benefit payment for married participants at retirement
• Provides an annuity to the participant for life, then continues to the surviving spouse (typically at 50% or more of the participant's benefit)
• Can be waived only with spousal consent (notarized or witnessed by plan representative)

Qualified Preretirement Survivor Annuity (QPSA)

• Provides an annuity to the surviving spouse if the participant dies before retirement
• Automatically applies to vested participants
• Can be waived only with spousal consent

Key Point: Profit sharing plans are NOT required to offer QJSA/QPSA unless they are the source of funds used to purchase annuities.

Commingled Accounts

Unlike defined contribution plans with separate individual accounts:

• DB plan assets are held in a single commingled trust
• Participants have accrued benefits, not account balances
• Investment gains/losses affect employer funding requirements, not participant benefits
• The promised benefit remains the same regardless of investment performance

Who DB Plans Favor

Defined benefit plans generally favor older employees because:

• Older employees have less time for contributions to grow through compound interest
• The actuarial cost of providing a given benefit is higher for older employees (less time to fund)
• Employers must contribute more per year for older employees to reach the same benefit level
• Credit can be given for prior service (not possible in DC plans)

Social Security Integration

DB plans can integrate benefits with Social Security using two methods:

Offset Method (DB Plans Only)

• Reduces the retirement benefit by a portion of the participant's Social Security benefit
• Only available to defined benefit plans
• Effect: Higher-paid employees receive relatively larger plan benefits

Excess Method (DB and DC Plans)

• Provides higher contributions or benefits for compensation above the Social Security wage base
• Available to both DB and DC plans

CFP Exam Tip: Only DB plans can use the offset method. Both DB and DC plans can use the excess method.

Key Characteristics Summary