Defined Benefit - A Full Example:
An employer, age 50, creates a plan for his company which is to include his employee, age 28, and himself. The retirement age in the plan is set at age 62.
The plan is created using a tiered formula where the owner is to receive 70% and the employee is to receive 20% of compensation for a set amount of years upon reaching age 62.
The plan will be calculated using years of plan participation limited to 10 years. (The 10 year limit simply means that any years of plan participation over 10 will not have an effect on benefit calculations).
The compensation of the employee is $50,000 and the compensation of the owner is $200,000.
In order to project a participant’s yearly benefit at retirement age, the following calculations will take place:(Assuming compensation stays constant)
For Owner, in the first year of the plan: 70% x 200,000 x (1/10) = 14,000
For Owner, in the second year of the plan: 70%x 200,000 x (2/10)= 28,000
For Owner, in the third year of the plan: 70% x 200,000 x (3/10)= 42,000
Therefore,assuming ten years of plan participation,the largest payment the owner would receive upon attaining the plans’ retirement age is $140,000 a year.
For Employee, in the first year of the plan: 20% x 50,000 x (1/10) = 1,000
For Employee, in the second year of the plan: 20%x 50,000 x (2/10)= 2,000
For Employee, in the third year of the plan: 20% x 50,000 x (3/10)= 3,000
Therefore, assuming ten years of plan participation, the largest payment the employee would receive upon attaining the plan’s retirement age is $10,000 a year. (20% x 50,000)
Now, assume that the owner will receive the full benefit ($140,000 a year) when he retires. If we take this figure and make it monthly, we create a projected monthly benefit of $11,666 (140,000/12). In other words, once the owner retires he should get $11,666 a month for a certain amount of years; this process of payment is referred to as an annuity.
An alternative to an annuity is a lump sum payment. The lump sum payment is a single payment comprised of all the projected monthly benefits multiplied by assumed interest rates and mortality tables. The maximum lump sum payment at this point in time is a little over two million dollars.
