Defined benefit plans

These are defined benefit plans for federal tax purposes; bar they have the portability advantages of defined contribution plans. In a defined benefits plan, the employer typically multiplies the employee’s average pay over the last few year of his or her pre-retirement employment by a predetermined multiple, based on years with the firm, and the result represents the person’s annual retirement income. To get the maximum benefit the person generally must put in his or her full 30 or so years with the firm. This approach tends to favor older employees (whose income is often higher and who have been with the firm for a number of years).

Younger employees and /or those who want the option of moving on with their vested pension benefits after say 7 or 6 years might prefer defined contribution plans. Here the employer gets the full vested value to that point of his or her pension.

Cash balance plans are a hybrid. Under these plans the employer contributes a percentage of employees’ current pay to the employees’ pension plan every year and employees earn interest on this amount. Cash balance plays provide the portability of defined contribution plans with the more predictable benefits of defined benefit plan.

Switching to cash balance plans can be problematic for employers, since doing so typically, puts older employees at a disadvantage. Partly in response to numerous lawsuits over this, in August 2006 President Bush signed into law the pension protection act. This makes it clear that employers who offer cash balance pension plans or other plans generally do not violate the Age Discrimination in employment Act.

Pension planning and the Law

Many federal laws impact pension planning, and in most cases it is basically impossible to formulate a plan without expert help. Most notably, the Employee Retirement Income Security Act of 1975 (ERISA) requires that employers have written pension plan documents and adhere to certain guidelines, for instance regarding who is eligible for the employer’s plan, and at what point the employer’s contribution becomes the employee’s (more on this below). ERISA protects the employer’s pension or health plans, assets by requiring that those who control the plans act responsibly. The Department of Labor says the primary responsibility of fiduciaries is to run the plan solely in the interest of participants and beneficiaries.

Employers (and employees) also usually want their pension contributions to be qualified or tax deductible so they must adhere to the pertinent income tax codes. Under labor relations laws, the employer must let their unions participate in pension plan administration. The Job Creation and Worker Assistance Act provide guidelines regarding what rates of return employers should use in computing their pension plan values.


ERISA established the Pension Benefits Guarantee Corporation (PBGC) to oversee and insure pensions should a plan terminates without sufficient funds. (The PBGC guarantees only defined benefits plans, not defined contributions plans. Furthermore it will only pay an individual a pension of up to maximum of about $49,000 per year for some one 65 years of age with a plan terminating in 2007. So, high income workers such as airline pilots may still see most of their expected pensions evaporate if their employers go bankrupt).

In developing pension plans to meet their needs employers must address several key policy issues:

Membership Requirements

For example what is the minimum age or minimum service at which employees become eligible for a pension? Under the Tax Reform Act of 1986, an employer can require that an employee complete a period of no more than two years’ service to the company before becoming eligible to participate in the plan. However, if it requires more than one year of service before eligibility the plan must have grant employees full and immediate vesting rights at the end of that period.