A "defined benefit plan" is a plan which provides each participant a specific benefit at retirement in the form of an annuity payable for life or an equivalent single cash payment. The amount of the benefit is generally related to the participant's compensation and length of service. The Internal Revenue Service allows a great deal of latitude in establishing the formula used to determine the annual retirement benefit, provided the formula does not discriminate in favor of employees considered to be highly compensated.
For example, a defined benefit formula could provide an annual benefit at age 65 of 50% of compensation reduced by 1/10 for each year of service less than 10 years. In this case, if a long-service participant earned an average of $50,000 per year and retired at age 65, he or she would be entitled to an annual benefit payable for life equal to $25,000 or a single sum payment equal to approximately $248,000 (the single sum payment is calculated on the basis of a prescribed interest rate and mortality table). The quantity of money needed to provide these benefits determines the amount of the company's annual contribution. This annual contribution will be a function of the compensation and the number of years until retirement of each participant as well as the investment performance of the assets.
The IRS has established a rigid set of rules to be followed when calculating the minimum required contribution and severe penalties are assessed if the contributions are not made. The calculation of the contribution must be made by an "enrolled actuary" who has been certified by the IRS to be knowledgeable and competent in the area of defined benefit pension plans.
There is no dollar limit on the amount of contribution to this type of plan. However, there are limits on the amount of annual benefit which may be provided to an individual and on the compensation which may be considered in the formula. That annual benefit limitation is the lesser of 100% of annual compensation or a flat dollar amount of $205,000 for 2013, indexed for inflation. The flat dollar amount is adjusted when the Social Security Retirement Age (SSRA) and the Normal Retirement Age (NRA) specified by the plan are not equivalent.
Generally, benefits are distributed only on retirement, death, disability or termination of employment. In the event of a participant's death, disability or termination of employment prior to normal retirement age, such a participant would be entitled to receive the vested portion of the benefit accrued to date. Benefit accrual may be based on either years of service with the company or years of participation in the plan. Most plans provide full vesting in the event of death or disability. This type of plan may also be combined with a defined contribution plan subject to the limitations of current law.