What it means
In a traditional defined benefit pension, the employer promises a set income in retirement and carries the investment risk. In a defined contribution plan, the employer pays a fixed contribution, and the employee carries the risk.
A target benefit plan combines features of both. An actuary, who is a specialist in pension mathematics, sets a target benefit for each employee, often a percentage of final pay.
The actuary then calculates the annual contribution needed to reach that target, using assumptions about investment returns, salary growth and retirement age. The employer pays that amount into the employee's own account.
The target is not a promise. If investments do better than assumed, the employee retires with more than the target, and if they do worse, with less.
The plan is therefore classed as a type of defined contribution plan for most legal purposes, despite its pension-style calculation. Because older workers have less time to build up savings, the required contribution for an employee who joins late is much higher than for a young employee aiming for the same target.
This makes the plan attractive to owners of small businesses who are older than their staff, since a large share of the contributions can go to them. Rules in the United States restrict this, so the plan must satisfy tests designed to prevent unfair favouritism.
The employer benefits from certainty over its annual cost and from being free of the open-ended risk of a traditional pension. Employees get a clear signpost for their retirement planning but have to accept that the outcome may fall short.
Because the contributions are calculated from assumptions, the plan needs regular reviews. If returns are persistently lower than assumed, the actuary may recommend higher contributions, and if staff leave early the unvested money returns to the plan.
The employer should budget for these adjustments from the start.
In practice
Real-world examples.
Example
A small architecture practice sets up a target benefit plan for its staff. The actuary calculates contributions of 8% of pay for younger employees and 18% for the 58-year-old founder. The founder's larger contribution reflects the shorter time available to build savings.
Example
An employee reviews her annual statement and sees a projected balance of $280,000 against a target of $300,000. Investment returns have been below the actuary's assumption. She decides to make extra voluntary savings to close the gap.
Example
A manufacturing firm moves from a traditional pension to a target benefit plan to stop its pension costs from swinging with markets. Annual cost is now a fixed, predictable amount. The board explains that employees now bear the investment risk and sets up a communication session so that staff understand the change before it takes effect.
Formula
Calculation
Required lump sum at retirement = target annual benefit x annuity factor
Annual contribution = required lump sum / accumulation factor
An employee earning $60,000 has a target benefit of $24,000 a year, which is 40% of pay. The actuary uses an annuity factor of 12.5, so the required lump sum = 24,000 x 12.5 = $300,000. With 25 years to retirement and an assumed return that gives an accumulation factor of 50, the annual contribution = 300,000 / 50 = $6,000. That equals 6,000 / 60,000 = 10% of salary.Case study
Seen in the real world.
Lindqvist Dental Group is an illustrative, fictional practice with 12 employees. The owner, aged 55, wanted to save for retirement faster than the standard savings plan allowed, while giving staff a meaningful benefit.
The actuary set a target benefit of 40% of final pay for everyone. Required contributions were 9% of pay for the youngest staff and 22% for the owner, whose salary of $150,000 meant a contribution of $33,000 a year.
The illustrative plan passed the fairness tests because staff received a real benefit, but the owner realised he would need to keep paying even in weak years. He also had to explain to employees that their final balances depended on investment returns and not on the target.
Watch out
Common mistakes.
- Treating the target as a guaranteed pension, when the final benefit depends on actual investment returns.
- Assuming every employee receives the same contribution rate, when the actuarial formula gives older entrants more.
- Overlooking the cost of the actuary and the testing, which can make the plan expensive for very small firms.
Questions
People also ask.
How is a target benefit plan different from a defined benefit plan?
In a defined benefit plan the employer guarantees the pension, while in a target benefit plan the employee bears the investment risk.
Who owns the money in the account?
The money belongs to the employee, subject to the plan's vesting rules, which set when the employer's contributions become fully theirs.
Why do older owners like the plan?
The formula allows larger contributions for older participants, which lets them save faster before retirement.
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