Defined benefit plan: what is it, and how does it work?
A defined benefit plan, or pension plan, promises a fixed monthly benefit at retirement.
What is a pension?
A defined benefit plan provides you with a set amount of money each month. Your employer largely funds this, with how much you receive depending on several factors.
More often than not, this type of plan comes in the form of a benefit amount calculated through a plan formula that considers factors such as retirement age, length of service, and pre-retirement earnings.
This is commonly known as a traditional pension plan. The U.S. Department of Labor provides the following example: one percent of your average salary for the last five years of employment for every year of service with an employer.
The number of defined benefit plans or pensions has fallen dramatically in recent years. According to the Bureau of Labor Statistics, from 1980 through 2008, participants in pension plans fell from 38 percent to 20 percent of the US workforce.
Defined contribution plans – such as 401(k)s – became more popular during this time.
According to PWC, the US market is more dependent than ever on defined contribution (DC) plans. Over 60 percent of US retirement assets are now in such plans, representing a widescale shift in investment risk from the corporate sector toward employees.
How do defined benefit plans work?
Retirees can receive payments through:
A single-life annuity – a fixed monthly benefit until death.
A qualified joint and survivor annuity – a fixed monthly benefit until death, which also allows the surviving spouse to continue receiving benefits afterwards.
A lump-sum payment – the entire value of the plan is paid in a single payment.
Another common DC plan is a cash balance plan.Here the promised benefit is defined in a fixed, stated account balance. How does that work?
Typically, each year the employee’s account is credited with a “pay credit” or “company contribution credit” and an “interest credit.”The former is a fixed rate of compensation from their employer, while the latter is a fixed or variable rate.
The investment credits are promised, meaning increases or decreases in the value of the investment do not impact on the amount agreed with the employee.
As with a cash balance plan, most traditional defined benefit plan benefits are protected, within certain limitations, by federal insurance provided through the Pension Benefit Guaranty Corporation (PBGC).
How do you access your defined benefit pension?
For those who still have a pension plan, how do you access them?
To qualify for benefits, you must be vested in a pension plan. Once you are vested in a retirement plan, you are eligible for benefits at retirement age, regardless of when you left the job.
Your plan will outline the vesting rules, but you must ensure you’ve met the requirements to be eligible for payments.
Defined benefit plans vest in different ways. Some plans vest immediately – meaning you own all of the money in your plan – while others vest over a period of time.
Once eligible, you can contact your previous employer or plan administrator, who will provide details on how to access your money.
If you believe you have a defined benefit plan somewhere, you’ll need to do some digging to find it.
This can involve contacting former employers and plan administrators, rolling over old plans into new accounts, contacting financial or insurance companies if your plan has been turned over to them, and even searching via the Pension Benefit Guaranty Corporation.
This federal agency insures private-sector traditional pension plans and pays out benefits up to certain limits if the plan fails.
How much tax will you pay on your defined benefit pension?
How much tax you pay in retirement depends on a few factors, including:
Retirement income sources
Total annual income
You must pay income tax on your pension and withdrawals from any tax-deferred investments in the year you take the money. Most retirement income can be subject to this, including pension payments.
This means the money your employer contributed, you contributed, and money you’ve gained through investments are subject to tax when you make a withdrawal.
One way around this is to roll over your money. If you choose to receive a lump sum distribution, the entire payment is taxed unless it is rolled over. When you do this, the amount is not taxed until it is distributed from your IRA.
If you need help managing your pension plan, seeking expert advice is important. A good place to start is Unbiased. Here you can get matched with an independent SEC-regulated financial advisor who can ensure you’re getting the most out of your current plan and are on course to achieving your retirement goals.
Senior Content Writer
Rachel is a Senior Content Writer at Unbiased. She has nearly a decade of experience writing and producing content across a range of different sectors.