What is a defined benefit plan?
This article explores defined benefit plans and sheds some light on how these retirement plans work and how they can benefit employees.
Summary
A defined benefit plan is a retirement plan with guaranteed benefits and is typically funded exclusively by employers.
Calculations use formulae based on the employee's length of service, age, and salary.
Payouts can be in the form of lump sums or annuities.
When planning for retirement, a financial advisor can offer the right advice to help you reach your retirement goals.
What is a defined benefit plan?
A defined benefit plan is a qualified retirement plan designed to provide employees with a predetermined and assured income stream during retirement.
Employers do most of the funding for these plans, although employees may sometimes contribute as well.
However, these retirement plans have become less popular with employers due to their associated costs and risks.
What is an example of a defined benefit plan?
Examples of defined-benefit plans include:
Pensions: Employers calculate a regular retirement income using the retiree's earnings and length of service. The employee will receive this amount at retirement age until their death. Some pensions transfer the benefit to the pensioner's spouse upon their death.
Cash balance plans: This type of defined benefit plan promises an employee a specific amount of money instead of a fixed monthly income when they leave the firm. The employee's length of service is the predominant factor used to calculate these plans.
Defined benefit plans offer employers and employees tax incentives.
Employers may deduct contributions, and the employees will only owe tax on these contributions once they start benefiting from the fund at retirement.
A defined benefit plan must comply with the Internal Revenue Code and the rules of the Employee Retirement Income Security Act of 1974 (ERISA).
How does a defined benefit plan work?
This type of retirement plan guarantees employees a specific amount of money upon retirement.
Every year, pension actuaries will calculate the future amounts expected to be disbursed from the plan. Their calculations will include necessary contributions to the plan to fund the year's planned payouts.
Employees may need to have a specific length of service to be entitled to a retirement benefit, a concept known as "vesting." They will not receive full benefits if they leave the company before fully vested in the defined-benefit plan.
How are defined benefit plan benefits calculated?
Defined benefit plan benefits are calculated using formulae, which may vary slightly from company to company.
The amount may be set for each year of service, or the formula may result in a predetermined percentage of an employee's earnings.
A typical formula calculates retirement plan benefits by using the employee's average salary during the last few years of employment, multiplying it by a specific percentage, and again by their years of employment.
Example 1 set amount: $800 x 20 (years of service) = $16 000
Example 2 percentage earnings: Average salary over the last five years x 1.5% x 20 (years of service) would provide the employee with 30% of their salary.
What are the defined benefit plan payment options?
Retirement payouts may come in two forms: an annuity or a lump sum.
In addition, you can structure an annuity in various ways:
Single life annuity: The plan pays out a specified monthly amount for the rest of the retiree's life. Upon death, beneficiaries will not receive further payments.
Single life with term certain: The retiree receives a monthly payment for a specified term. If they die before the term ends, beneficiaries will receive payments for a predetermined number of years.
50% joint and survivor: When the retiree passes away, the spouse will continue to receive payments equal to 50% of the original amount.
100% joint and survivor: Upon the retiree's death, the surviving spouse will receive the same monthly payments until their death.
The more stipulations included in an annuity, the lower the monthly payments retirees will receive.
Annuities will benefit retirees in good health who expect to live a long time.
On the other hand, those in poor health or who need their money all at once may benefit more by selecting a lump sum.
How do defined benefit plans and defined contribution plans differ?
Companies offer different types of retirement plans, and it's vital to understand the inner workings of your post-employment funding.
In previous years, defined benefit plans were the standard type of retirement funding. However, many employers are reluctant to absorb the expenses and risks attached to these plans, preferring to offer defined-contribution plans.
Defined benefit plans guarantee a set amount of money when an employee retires. Employers are responsible for ensuring sufficient funds to pay out the promised amount. The Pension Benefit Guaranty Corporation provides federal insurance, ensuring that funds are protected.
Defined contribution plans do not guarantee a specific amount of money. These plans require employees to pay into their retirement plan within annual limits. The final payout depends on the employee's contribution amount and the investment's performance. The 401(k) and 403 (b) are prime examples of defined contribution plans.
With defined contribution plans, employers sometimes contribute to the fund, usually by matching the employee's contribution. The company will only contribute up to a specific amount. Some employers allow their employees to have both types of retirement plans.
To avoid any retirement planning risks or pitfalls, employees should always do their utmost to understand the type of retirement funding their company offers. If it promises a pension plan, the employee should find out whether it pays out a lump sum or monthly amounts, the vesting schedule, and how it calculates the final amount.
Get expert retirement advice
A defined benefit plan is an employer-sponsored pension plan that guarantees employees a retirement income.
Knowing how much they will receive upon retirement and that their employer assumes the risk with these pension plans brings security to many employees, enabling them to make detailed plans for their retirement.
It’s important never to underestimate the importance of planning for their retirement. For the sake of financial security when you retire, it's essential to discuss your needs with a financial advisor.
Unbiased can match you with the right advisor who will provide expert financial advice and guide your decision-making in a way that sets you up for a financially secure future.
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