Defined benefit pension plan installation and defined benefit pension plan maintenance can present problems for the unwary. This information on defined benefit pension plans will help you avoid them.
Tip: A defined benefit pension plan is one in which the benefits are first "defined" and the annual employer contributions needed to provide these benefits are then determined. For a successful defined benefit pension plan, each of the following five plan functions must be well executed: design, investment, administration and compliance, communication with employees and control of expenses. An actuary is crucial to the success of a defined benefit pension plan.
Trap: Employers are frequently unprepared for the demands that a defined benefit pension plan can place on an organization. Among these are the necessity of making the annual contribution in a timely manner despite financial hardship, the complexity of defined benefit pension plan administration and the difficulty in effectively communicating the plan to employees.
Tip: A defined benefit pension plan must be carefully designed. To accomplish this, sophisticated actuarial calculations are required to determine a benefit formula that is consistent with the employer's objectives and budget.
Trap: Poorly designed defined benefit pension plans may not produce the benefits desired by the employer for the participants, necessitating plan redesign or termination. Moreover, once the benefit formula is determined, an annual contribution must be made by the employer to provide these benefits, despite financial difficulties. To avoid future problems, employers should insist on benefit projections and costs under various assumptions before a defined benefit pension plan is established.
Tip: Plan investment options must be carefully established and monitored. Since benefits are ultimately provided from employer contributions and their investment earnings, the employer's annual costs are reduced or increased by investment performance. Therefore, investments should not be overly aggressive; if a large loss occurs, contributions may require a dramatic increase. Employers need not worry as much about fiduciary liability with investment performance as in a defined contribution retirement plan.
Trap: Fiduciary responsibilities should be fully understood by the employer prior to a defined benefit pension plan's establishment. Small defined benefit plans are especially vulnerable to self-dealing between the employer and the plan. These are referred to as prohibited transactions and could lead to severe penalties from the Department of Labor.
Tip: Defined benefit pension plan administration and compliance requirements must be assigned and monitored. A third party administrator and actuary will often be needed for this function. A description of all necessary services should be indicated by the defined benefit pension plan provider when the plan is established. Controls are needed to ensure that the data used to calculate participants' benefits are accurate. If these controls are not properly maintained, mistakes could easily occur and, if serious enough, ultimately result in plan disqualification by the I.R.S..
Trap: Distribution of a participant's benefits based on incorrect data, delay in making the required employer annual contribution even a few days past the due date and the "overfunding" or "underfunding" of a defined benefit pension plan are examples of difficulties that can be encountered. Precautions should be taken to avoid such possibilities.
Tip: Employees are frequently unaware of how benefits are accrued in a defined benefit pension plan. Care should be taken to ensure they understand the plan's benefit formula as well as possible. Poor understanding of the plan's benefits by employees could jeopardize the desire of employers to continue the plan. The defined benefit pension plan should be explained to employees before it is adopted.
Trap: Employers should be especially careful with all communication material containing benefit calculations. Annual employee benefit statements should be reviewed for reasonableness before they are released; at the very least, the data used should be verified.
Tip: Defined benefit pension plan expenses can arise from any of the four areas mentioned above. Employers should be cognizant of all fees when the plan is established and make provision for their periodic review.
Trap:Defined benefit pension plan fees are often high because of sophisticated actuarial work; however, failure to use sufficient actuarial services may cause problems and result in unnecessary costs.