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Target Benefit Retirement Plans Offer Employers Unique Options

Filed under Managing the Workplace. Fact checked on May 24, 2012.

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Target benefit retirement plans are a hybrid-type of plan that have both defined benefit plan and defined contribution plan characteristics.

Employers may choose to offer a hybrid plan as a retirement benefit for their employees. As their name implies hybrid plans form a category of retirement plans that combine certain features of both defined benefit and contribution plans. Employers interested in offering a hybrid-type of plan as an employee benefit should consider a target benefit plan, which can be structured to provide the owner of a business with valuable benefits.

A target benefit plan is a plan in which you, as the employer, establish a target benefit for your employees, but where each employee's actual pension is based on the amount in the employee's individual account. In that sense, target benefit plans combine elements of defined benefit and defined contribution plans. These plans use a formula to define the distribution of benefits and at the same time they take the cash contribution feature from the defined contribution plan.

The best way to see how a target benefit plan works is to check out our case study. We've provided an example that compares a straight profit-sharing plan with a target benefit plan.

Case Study

Here's an example of how a target benefit plan might work in a two-owner company with three employees. Here's some general information about the Makingitbig Corporation and its employees and owners:

Makingitbig Corporation Census
Name of employees
Age
Years of
Service
Annual
Compensation
Owner John 50 25 $60,000
Owner Jane 49 25 $60,000
Jack Employee 30 5 $35,000
Jill Employee 27 4 $30,000
Pat Employee 26 3 $27,000

To illustrate the owners' advantage in having a target benefit plan, let's see how a straight profit-sharing plan would serve its participants at the Makingitbig Corporation. Let's assume a straight profit-sharing plan where 15 percent of compensation is contributed for each employee.

Makingitbig Corporation Profit-Sharing Proposal-
15 percent of Individual Compensation
Name of
Employee

Contribution
Amount
Percentage of
Plan's Total
Contribution
Owner John 9,000 28.3
Owner Jane 9,000 28.3
Jack Employee 5,250 16.5
Jill Employee 4,500 14.1
Pat Employee 4,050 12.7

In the straight profit-sharing plan, the amount of the plan's total contribution is allocated by a percentage that is calculated by dividing each employee's individual contribution by the total amount of contributions (for Owner John, the percentage is 9,000 divided by 31,800 = 28.3 percent). There is no advantage unless you contribute more for each employee.

Now let's assume a target benefit plan that weighs age and service in determining contributions.

Makingitbig Corporation Target Benefit Plan
Name of
Employee
Contribution
Amount
Percentage of
Plan's Total
Contribution
Owner John 13,000 40.8
Owner Jane 13,000 39.3
Jack Employee 2,700 8.5
Jill Employee 2,200 6.9
Pat Employee 1,400 4.4

As you can see from the example above, a much greater portion of the total contribution (80 percent compared to 56 percent) is shifted to the business owners in a plan that considers owners' higher ages and longer service. Determining the formula is something that your financial adviser can help you with.

Disadvantages of Target Benefit Plans

There are a couple of drawbacks to a target plan. One major drawback is its tendency to backload benefits. While defined benefit plans typically take into account future salary increases in their funding (thus spreading their effect over many years), target benefit plans do not recognize future salary increases in advance.

Accordingly, contributions to target benefit plans can rise sharply as the age and salary levels of participants increase. A steep increase results from the plan's method of calculating contributions that requires that each increase be funded over successively shorter time periods. In other words, because years of service and generally a person's salary (and consequently their contribution amount) go up, the fund has to make up a lot of ground as the person draws closer to retirement age. This is definitely something to consider if you employ — or plan to employ — young, professional people who may stay with your business for a long time.

On the bright side, when the backloading effect of the target benefit plan is carefully communicated to employees, it can be a powerful incentive for individuals to delay retirement or continue employment.

As you consider offering a target benefit plan to your employees, be sure you understand the disadvantages of this option, and ask your financial adviser whether a target benefit plan makes sense for you.

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