Types of Qualified Retirement Plans:
- Defined Contribution Plans:
- These are basically retirement accounts. They are referred to as Defined Contribution Plans because it is the “money in” that is defined. The plan participant bears the investment risk. The value is easy to determine (but look out for loans and vesting).
- Typical Defined Contribution plans are 401(a), 401(k), 403(b), 457 Plan, Federal Thrift Savings Plan, Money Purchase Plan, Employee Savings Plan, Profit Sharing Plans.
- Defined Benefit Plans:
- These are traditional pension plans. They are referred to as Defined Benefit because it is the “money out” that is defined. Retirement benefits are payable to the plan participant for life, with the monthly amount based on the employee’s years of service and final average pay. The plan sponsor bears the risk of investment.
- Benefits are paid over the course of the employee’s lifetime (or some other chosen period).
- Cash Balance Plans
- Even though they look like defined contribution (401(k)) plans, Cash Balance Plans are defined benefit plans. The difference is the under a defined contribution plan, the employee bears the risk of investment. Under a cash balance plan, the employer bears the risk of investment. The employer deposits a percentage of the employee’s salary (usually 4 – 7 %) into a “hypothetical account”. The “account” is credited with a fixed interest rate, often tied to 30 year Treasury Bonds. This is the “assumed rate of investment return”. The actual rate of investment return depends on how the assets are invested. If the actual rate of return is greater than the assumed rate of return, the employer can invest less now, and still end up with the predicted amount for the employee’s retirement.
- Many cash balance plans do not permit distributions until the employee is eligible to retire (usually age 55).