Close-Up: Defined-benefit and -contribution Plans

Physician's Money Digest, Nov30 2004, Volume 11, Issue 22

Presented by McNeil Makers of

Tylenol

n.

Defined-benefit Plan: A pension plan in which an employer funds employee retirement benefits by investinga fixed amount according to years of service and salary.

n.

Defined-contribution Plan: An employer-sponsored plan in which contributions are made to individualparticipant accounts, with the final benefit consisting solely of assets that have accumulated in the accounts.

Whether you own your own medical practiceor are employed by a large grouppractice, you've no doubt been facedwith deciding what kind of retirementplan to set up or join. Essentially, there are two options:a defined-benefit or defined-contribution plan. Based onthe brief definitions above, the two options might seemto be quite similar. But upon closer examination, thereare major differences.

For example, according to Intuit (www.intuit.com),a defined-contribution plan defines how much you andperhaps your employer contribute, without specifyingthe exact dollar amount you will receive in benefitswhen you retire. In contrast, a defined-benefit plan spellsout exactly how much money you will receive uponretirement and calculates how much you need to contributeto achieve that goal. Which one is right for you?

Defined-contribution Plans

There are different types of defined-contributionplans, including 401(k), money purchase, profit sharing,and employee stock ownership plans. They areconsidered less expensive and more flexible thandefined-benefit plans, and in recent years havebecome the benefit plans of choice among a growingnumber of employers.

With defined-contribution plans, each participanthas an individual, separate account, even if the only participantin the plan is you. Benefits, according toToolKit.com, are determined by how much is contributedto your account and how well the pension fundinvestments perform. A limit is set on the dollar amountof annual contributions that can be made to this type ofplan. For 2004, that figure is the lesser of $41,000 or100% of the employee's annual earnings.

Defined-contribution plans are generally easy tounderstand. Also, participants have a certain degree oflatitude in terms of how much they choose to save.Participants can benefit from good investment decisionsand results. In addition, lump-sum distributions may beeligible for special 10-year averaging. However, due tothe cap that is placed on how much can be contributedannually in a participant's name, it is difficult to build asignificant nest egg if a plan is established later in life.And just as participants can benefit from positive investmentresults, they can also bear the burden of investmentrisk. In addition, not all employers choose to contributeto defined-contribution plans (ie, match employeecontributions), which makes them reliant on theemployee's ability to save.

Defined-benefit Plans

In contrast to defined-contribution plans, defined-benefitplans promise that a participant will receive aspecific monthly benefit at the time of their retirement.This is calculated through a formula that considers aparticipant's salary and years of service. The actuarialcomputations required to arrive at this specific benefitmake defined-benefit plans more costly to administer,and frequently more difficult to understand.

To figure out how much should be contributed, planadministrators consider how much money must be contributednow—taking into account a reasonable expectedrate of return—so that there is enough money tomake the fixed-benefit payment in the future. However,the maximum amount that can be contributed each yearis the lesser of $160,000 or your average compensationfrom your 3 highest consecutive calendar years. Forexample, if the income from your 3 highest incomeyears totaled $150,000, the maximum amount youcould contribute would be $50,000.

In addition to employer contributions, plan participantscan make voluntary contributions to theiraccounts. Even though the contributions are nondeductible,the earnings on them are tax-free until distributedin future years. The limit on these contributionsis 10% each year.

Defined-benefit plans provide guaranteed incomesecurity with no investment risk to participants andare not dependent on the participant's ability tosave. However, they are often difficult for participantsto understand, costly to administer, and notbeneficial for employees who might quit prior toretirement.

Types of Defined-contribution Plans

Defined-contribution plans encompass a broadrange of programs, including the following:

• Profit sharing plans—These are now the mostpopular type of plan, especially for small businesses.They offer great flexibility, are simple to administer,and enable employers not to contribute to theplan in any given year.

• Money purchase plans—With these, employersare obligated to contribute even if the company didnot make a profit. The contributions are determinedby a specific percentage of each employee's compensationand must be made annually.

• 401(k) plans—These enable employees toauthorize their employer to reduce their salary andcontribute to the plan the salary reduction on a pretaxbasis. For 2004, employee annual contributionsare limited to $13,000; those aged 50 and older cancontribute an additional $3000.

Pop Quiz

1) Defined-contribution plans do not specify the exactbenefit amount to be received. True or false?

  1. True
  2. False

2) Defined-benefit plans do not specify the exact benefitamount to be received. True or false?

  1. True
  2. False

3) Types of defined-contribution plans include:

  1. Profit sharing plans
  2. Money purchase plans
  3. 401(k) plans
  4. All of the above

4) The dollar amount on annual contributions todefined-contribution plans for 2004 is:

  1. The lesser of $40,000 or 100% of the employee'sannual earnings
  2. The greater of $40,000 or 100% of the employee'sannual earnings
  3. The lesser of $41,000 or 100% of the employee'sannual earnings
  4. The lesser of $40,000 or 50% of the employee'sannual earnings

5) Contributions to defined-benefit plans are calculatedusing the following:

  1. Actuarial computations
  2. Strict accounting measures
  3. A high-powered calculator
  4. A crystal ball

Answers: 1) a; 2) b; 3) d; 4) c; 5) a.