What is a Defined Benefit Plan?
A defined-benefit plan is an employer-sponsored retirement plan in which employee benefits are calculated using a formula that takes into account several factors, including length of employment and salary history. The company is in charge of managing the plan's investments and risk, which is usually handled by an outside investment manager. Unlike a 401(k), an employee cannot usually simply withdraw funds. Rather, they become eligible to receive their benefit as a lifetime annuity or, in some cases, as a lump sum when they reach the age specified by the plan's rules.
This type of plan, also known as pension plans or qualified-benefit plans, is referred to as "defined benefit" because employees and employers are aware of the formula for calculating retirement benefits ahead of time and use it to define and set the benefit paid out. This fund differs from other retirement funds, such as retirement savings accounts, in that the payout amounts are determined by investment returns. Poor investment returns or incorrect assumptions and calculations can lead to a funding shortfall, in which employers are legally required to make up the difference with a cash contribution.
Defined Benefit Plan payment options
When it's time to cash in on your retirement, you'll usually get a lump sum or an annuity that pays you monthly for the rest of your life. Choosing between the two can be difficult, especially since an annuity can be structured in a variety of ways:
• One-time payment for life. You will receive a monthly payment for the rest of your life, and your beneficiaries will receive no further payments if you die.
• Single life with a fixed term. You get a monthly payment, and if you die before the specified term is up, your beneficiaries get payments for a set number of years.
• 50% joint and 50% survivor. When you die, your surviving spouse will receive monthly payments for the rest of their lives equal to half of your original annuity amount.
- Completely joint and survivor. When you die, your surviving spouse will receive monthly payments equal to 100 percent of your original annuity for the rest of their lives.
Adding more conditions to your annuity usually results in lower monthly payments. However, if you're in good health and expect to live a long life, annuity payments are usually the best option. If you're in poor health and expect to retire soon, a lump sum may be the best option. You can also take a lump sum payment and invest it or use it to purchase your own annuity.
Types of Defined Benefit Plans
1. Pension Plans
Pensions Most people consider a defined benefit plan to be a pension: a monthly benefit starting at retirement based on a formula that takes into account how long a worker worked for a company and how much they earned.
Employees must usually stay with a company for a certain amount of time in order to receive pension benefits. An employee is considered "vested" after accumulating the required tenure. Vesting requirements for pension plans may vary. For example, after one year of service with a company, an employee may be 20 percent vested, entitling them to retirement payments equal to 20 percent of the full pension.
Vesting schedules are another feature that is common in defined contribution plans. Approximately half of all 401(k) plans have some kind of vesting schedule for employer contributions.
2. Cash Balance Plans
Cash balance plans are defined benefit plans that provide employees with a predetermined account balance at retirement or when they leave the company, rather than a predetermined monthly benefit. As a result, many people consider them to be a cross between traditional pensions and 401(k)s.
Employers continue to bear all investment risk associated with managing retirement funds, but they do not guarantee indefinite benefit payments. Instead, you are guaranteed up to a certain amount of cash.
Cash balance plans generally calculate benefits based on your total working years with a company, not just your most recent or highest earning period, which means that some people will receive fewer benefits if their companies switch from a pension plan to a cash balance plan.
Employers usually compute the cash balance using two factors: pay credits and interest credits. Each year, an employee's account is typically credited with a pay credit (such as 3 percent of compensation from their employer). They'll also get an interest credit for the money they have in the account (usually a fixed or variable rate linked to a benchmark such as the 30-year Treasury bond).
Participants have an annual account balance that they receive when they leave the company and that becomes theirs upon vesting. They will typically have the option of receiving their balance as an annuity that makes regular payments over time or as a lump sum that they can roll over to an individual retirement account (IRA) or another company's plan.
Advantages of Defined Benefit Plans
• Retirement paycheck security: In a defined benefit plan, employee benefits are guaranteed, providing employees with the security of a regular paycheck in retirement.
• Payments are not affected by market fluctuations: The employee retirement benefit remains constant regardless of what happens to the underlying investments.
• Spousal support: After the employee's death, a spouse may be able to continue receiving guaranteed payments.
• Tax advantages for employers: Contributions to defined benefit plans are generally tax deductible for employers.
• Increased employee retention: Defined benefit plans can keep employees with a company for a long time while they wait to vest and earn the most retirement benefits.
Disadvantages of Defined Benefit Plans
• No investment options: Employees have no say over where their money is invested.
• It takes time to vest: If a company requires an employee to stay for five years to vest and the employee leaves after three, all of their earnings remain with the company.
- Lack of portability: When an employee changes jobs, it may be difficult to transfer money from one plan to the next, though cash balance plans may make this easier. This does not preclude you from receiving your total collective benefits in retirement. You'll just have to manage multiple streams of income.
• No opportunity to increase your benefit: Because the benefit formula is the benefit formula, an employee's retirement paycheck cannot be increased. Employees can contribute more money or invest more aggressively with defined contribution plans to increase their returns. Those with defined benefit plans can supplement their retirement savings with IRAs, which are discussed further below.
• Expensive to maintain: Defined benefit plans are more expensive to maintain than defined contribution plans because they provide guaranteed payments regardless of market conditions.