A Brief History of Time -- Since 1983
Section 415(e) came about in the mid-1980s as part of the revenue-raising tax bill Tax Equity and Fiscal Responsibility Act (TEFRA). This particular code section placed a nasty and onerous limit on employers who maintained both a defined contribution plan (such as a profit sharing or money purchase plan) and a defined benefit pension plan. Briefly, if any employee (not just the business owner) were covered by both plans, then the maximum contribution allowed to the defined contribution plan plus the maximum benefit allowed to the defined benefit plan were scaled back to about 70 percent of the otherwise maximum amounts.

So most employers opted to make the maximum contribution to the defined contribution plan and either freeze, scale back or altogether terminate their defined benefit plan. This led to a lot of federal tax revenue (hey, that’s what TEFRA was really all about), and it also unfortunately led to the termination of many defined benefit plans in the mid-1980s.

We Love Our Country... It’s Our Government We Fear
Section 415(e) was widely regarded as the last government assault on the revered defined benefit plan. DB plans were at one time the most prominent type of retirement plan in America. As recently as the 1970s, the words "pension plan" and "retirement income" were considered synonymous. With the invention of the 401(k) plan in the late 1970s, employers began to divert their benefit dollars away from DB plans and into 401(k) matching contributions. In 1983 when TEFRA was passed, the DB plan began its death march. Nearly half the DB plans in existence in 1980 no longer exist.

Pension consultants got very creative in their attempts to save the DB plans for their clients, recognizing that these plans were still the most economical way to accumulate tax-deferred wealth. They designed unusual benefit formulas, and they invented a hybrid known as the Cash Balance Plan. (Cash balance plans are under separate attack for age discrimination, but that is another story.) With the termination of many DB plans, defined contribution plans rose up to take their place. A more transient work force and the ability to defer tax on paychecks have made 401(k) plans the most popular type of retirement vehicle ever.

Do the Math
Unfortunately, no defined contribution plan can allow an older employee to accumulate the money needed for retirement in today’s economy. The limit on contributions to a defined contribution plan (actually, to all defined contribution plans of the employer) is still $30,000 annually. And if the employer maintains a 401(k) plan only, the deferral limit is just $10,500. An employee making the maximum 401(k) contributions starting at age 45 could expect to accumulate about $285,000 at age 60 (assuming 8% investment earnings, and assuming he or she never took a hardship distribution or a loan). This would translate into less than $2,500/month in life payments (less if some of the payments were guaranteed). And an employee starting at age 50 could count on less than $1,400/month.

Defined Benefit Plan -- The White Knight
The DB plan is the answer in this situation. IRS places no limit on the amount that an employer may contribute to a DB plan. The limit is instead placed on the benefit produced by the plan’s formula. Think of the funding of the benefit like the mortgage on a home. The "mortgage" is the pot of money that must be accumulated at one’s retirement age to fund annuity payments for the remaining life of the retiree. For an employee age 35, assumed to retire at 65, the "mortgage" is funded over 30 years, and required payments are small. For an employee age 55, the same mortgage is funded over just 10 years, so the payments (and therefore, the deductible contributions) are much higher. Both employees can accumulate a full pension under the right benefit formula.

Righting the Ship
Congress finally righted themselves on this issue when they recently repealed Code Section 415(e). Beginning in the year 2000, employers no longer need limit either the defined contribution plan or the defined benefit plan for employees covered by both plans.

The difference in what business owners can defer for themselves through a combination of defined contribution and defined benefit plans is startling:

The annual difference in what a business owner can defer personally can range from $20,000 to $60,000, depending on age. This represents significant additional tax deferral on not just the amount contributed annually, but on the investment earnings as well.

In the case of the business owner who actually TERMINATED the employer’s defined benefit plan because it was no longer worth the trouble, the additional deferral possibilities are even greater.

If you see a business owner who could benefit from additional tax deferral, and no defined benefit plan is in place for the business, now is the time to adopt a defined benefit plan. They are back and better than ever.