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.
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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