What is a target benefit plan?
A target benefit plan is similar to a defined benefit (DB) plan in which contributions are based on projected retirement benefits. However, unlike a defined benefit plan, the distributions that participants in a target benefit plan receive at retirement are based on investment performance and are therefore not guaranteed.
Note that a target benefit plan is not the same as a target date fund, which can be found in defined contribution (DC) retirement accounts like 401 (k) plans.
Key points to remember
- A target benefit plan offers contributions based on projected retirement benefits.
- It is similar to a defined benefit plan, but unlike a defined benefit plan, pension distributions paid to participants in a target benefit plan are not guaranteed.
- The market has an impact on a target benefit plan.
- Monthly benefits for target benefit plans may increase when the market is doing well, but decrease when the market is down.
- Target benefit plans offer more certainty than defined contribution plans or 401 (k).
How a target benefit plan works
Target benefit plans have certain attributes of pension plans in that they provide a monthly benefit to members or employees. However, a target benefit plan transfers the risk of whether there are sufficient funds in the plan to the employees, whereas in a pension plan the risk lies solely with the employer to provide the benefits.
A target benefit plan provides employees with an estimated monthly benefit target, but that target may change over time, based on returns on investment. In other words, there is no guarantee that the monthly benefit will be there at retirement, nor is there any guarantee of the monthly amount.
The target benefit plan also has some similarity to a defined contribution plan in that contributions are mandatory. In a defined contribution plan, an employee or an employer makes annual contributions according to the percentage required by the plan. For example, a plan that requires a 5% contribution means that the employer annually pays 5% of the salary of each eligible employee to their separate account. Contributions must be made whether or not the business makes a profit.
Defined contribution plans
A target benefit plan shares some similarities with a defined contribution (DC) plan, such as a 401 (k) plan. Defined contribution plans are pension plans in which employees contribute a fixed amount or a percentage of their salary each cycle. An employer will often match an employee’s regular contribution to a defined contribution plan.
In both a defined contribution plan and a target benefit plan, funds are invested to generate returns so that there is enough money in retirement for employees. Also, as with a 401 (k), employees run the risk that there is not enough money in the fund. However, benefits paid to the employee under a target benefit plan – although not guaranteed – may be more certain than benefits under a defined contribution plan.
Target benefit plans vs defined benefit plans
PD and CD plans have drawbacks. While defined benefit plans force employers to take greater risks, defined contribution plans shift the burden of those risks onto workers and retirees. Both have had mixed results.
Defined benefit plans have a slightly broader scope than target benefit plans. In a defined benefit pension plan, a member receives a fixed retirement benefit based on earnings, age and years of service with a particular employer. DB plans are guaranteed by the Pension Benefit Guaranty Corporation (PBGC), an agency of the federal government, while target benefit plans are not guaranteed.
Cash Balance Plan
There are other variations of defined benefit plans that include a cash balance. In a cash balance plan, an employer credits a participant’s account with a set percentage of their annual compensation plus interest. The company bears sole ownership of the profits and losses of the portfolio.
412 (e) (3) Plan
In a 412 (e) (3) tax system, designed for small businesses, any amount the owner contributes to the plan becomes immediately available as a tax deduction for the business. The investments that can fund this type of plan are guaranteed annuities or a combination of annuities and life insurance. 412 (e) (3) plans are fully insured plans.
Asset or investment values, as well as monthly benefits in target benefit plans, are moving targets. In other words, profits are reduced after market declines and increased when the market is doing well. However, target benefit plans may offer more certainty than defined contribution plans. Target benefit plans have emerged in many places outside the United States, including the United Kingdom and the Netherlands.
Does a Target Benefit Plan Favor Older Employees?
Yes, target benefit plans generally favor older employees. Indeed, a characteristic of target benefit plans is that age is one of the determinants of plan contributions.
Is a Defined Contribution Pension Plan a Defined Benefit Plan?
Yes, a defined contribution pension plan is a defined benefit plan. This is a defined contribution employer plan, much like a 401 (k) plan. The difference between a 401 (k) pension plan and a defined contribution pension plan is that contributions are made only by an employer, not by the employee. Contributions are also set annually.
Can I have a 401 (k) plan and a defined benefit plan?
Yes, you can set up a defined benefit plan and a 401 (k) solo plan, called a 401 (k) or DB (K) defined benefit plan. The passage of the Pension Protection Act of 2006 (PPA) made this possible.