When it comes to retirement plans, each plan can fall into two basic categories: defined benefit plans or defined contribution plans. Within each category, there are subcategories of plans, each with its own features and unique benefits. There are also hybrid plans available known as DB/DC combo plans that combine features from both defined benefit and defined contribution plans with coordinated benefits.
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Defined Benefit vs. Defined Contribution Plans: What’s the Difference?
Defined Benefit Plans, also known as pension plans, promise participants a specific lifetime benefit at retirement. Employers will designate a set amount for each employee that is based on individual factors such as salary and years of service. With this type of plan, the employer bears the investment risk as participants will receive the promised benefit. The employer is responsible for making sure enough funds are available to pay.
On the other hand, a defined contribution plan is funded primarily by each participant with a set dollar amount or percentage of pay. This can be funded by the employer, the employee, or both. The most common type of defined contribution plan is a 401(k) where employees can defer a portion of their salary via a payroll deduction to the plan. Employers will often elect to make matching contributions up to a certain dollar or percentage. In this type of plan, the employee bears the investment risk. Once deposits are made, the amount that a participant has available to withdraw will be based upon the value of the investments when a withdrawal is requested. Most defined contribution plans provide for the participant to direct his or her own investments.
What is a DB/DC Combo Plan?
While many employers choose to select either a defined benefit or defined contribution plan, there are also hybrid plans known as DB/DC combo plans. This plan refers to a defined benefit plan that is paired with a defined contribution plan in order for employers to increase their deductible limit and reduce retirement benefit costs. A common example of a DB/DC combo plan is a 401(k) profit-sharing plan paired with a cash balance plan.
When deciding if a DB/DC Combo Plan is Right for your Organization, there are factors to consider.
DB/DC Combo Plans: Factors to Consider
Combined Deduction Limit
- Under IRC Section 404(a)(7), employers who maintain both DB and DC plans and have at least one person covered by plan, there are deduction limits. For example, if a plan has a minimum contribution of $100,000 with a maximum deductible of $300,000 and an employer wants to make a contribution to a defined contribution plan greater than 6%, the ability to deduct $300,000 no longer exists. The $100,000 minimum contribution is then set as the maximum deductible contribution.
Pension Benefit Guaranty Corporation (PBGC) Coverage
- Defined benefit plans offered by private-sector employers are insured by PBGC because they promise a specified benefit at retirement. However, defined contribution plans are not insured by PBGC since they do not have a specified benefit amount.
- PBGC also does not insure plans offered by professional service employers that have not covered more than 25 active participants since the enactment of ERISA, church groups, or federal, state, or local governments.
Top Heavy Minimums
- In many cases, a DB/DC Combo Plan for a small organization will be top heavy. This means that more than 60% of the combined benefits are for the owners and executive officers which then triggers certain minimum distribution requirements. The most common design is to fund the minimum in the profit-sharing plan which equals about 5% of pay.
Meaningful Benefits
- Defined benefit plans are required to undergo a minimum participation test that entitles 40% of eligible participants to receive a meaningful benefit. The IRS defines a benefit as meaningful if it provides at least 0.5% of compensation at retirement.
Non-Discrimination Testing
- Cash balance plans are designed to provide owners with substantial benefits, but they must pass nondiscrimination tests if a non-uniform allocation is used. To address this, employers opt to combine them with a safe harbor 401(k) plan to pass testing. Employers take the aggregate benefits between the two plans to see if employees are provided a sufficient benefit as compared to the highly compensated employee group. A common design is to provide most employee benefits in the 401(k) profit-sharing plan so that employees will carry the investment risk and keep PBGC insurance premiums lower.
Plan Document Coordination
- Coordination of DB/DC combo plans can be tricky, to avoid issues, employers should define tiers and credits carefully and have a consistent highly compensated employee definition between defined benefit and plan sponsor documents.
Considering a DB/DC Combo Plan?
There are many ways to design a DB/DC Combo plan depending on the organization’s objectives. Our team at California Pensions can help design a combo plan that is right for you. To learn more about how to design an effective retirement plan to meet your organization’s goals, contact the team at California Pensions today.
