What’s a Defined Benefit Plan? Pros, Cons and How It Compares

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Defined benefit plans, also known as pensions, have steadily decreased since the 1970s. The most recent data from the Bureau of Labor and Statistics show that less than 10% of private sector employees have access to a defined benefit plan. Since it’s not common option, it’s only natural to ask, “What is a defined benefit plan?”

What Are the Features of a Defined Benefit Plan?

A defined benefit plan guarantees retirement benefits for an employee. Some of the features include:

• Employer sponsored: The employer funds and manages the plan. 
• Fixed benefit: The retirement benefit is predetermined by a formula and doesn’t rely on investment performance or individual contributions. 
• Lifetime income: Employees are guaranteed a lifetime payout. 
• Vesting requirement: Employees are required to work for a period of time to be eligible for a defined benefit plan. 

How Defined Benefit Plans Work

Defined benefit plans are employer-sponsored accounts that provide retirement benefits to employees.

The guaranteed retirement funds are based on a set formula that factors years of service, final average salary and a benefit multiplier, which is determined by the company. Employers manage this fund, as well as plan and manage investments. It’s a responsibility that employers take on to ensure there’s enough money to meet future payouts. 

Employees are required to meet a vesting period and entitled to receive lifetime monthly income upon reaching retirement age.

Employer Contributions

In a defined benefit plan, employers are responsible for making contributions to a fund. Those contributions are determined by the following factors:

• Amount is calculated by an actuary. An actuary determines risk assessment, and can calculate how much an employer should contribute.
• Employer makes the investment. Employer makes investment decisions and decides on the best strategy for future benefits. 
• Investment amounts vary. The amount the employer can contribute will vary year to year. 
• Funding requirement minimums. Employers have to fund the defined benefit plan to meet the minimum requirements set by government regulations. 
• Impact of market. During economic downturns, employers may need to increase funds to cover shortfalls in the fund. 

Formula for Calculating Benefits

The typical formula for calculating benefits involves multiplying three different factors:

1. The number of years worked at the company
2. Salary (an average of a specified number of years)
3. A specified percentage (also called benefit multiplier) set by the company

An Example

Suppose Employee A worked for their employer for 25 years, with a pension plan that provides 2% of their average salary over the last four years of $125,000 for each year of service. A’s annual pension would be calculated as follows: 25 x 2% x $125,000, resulting in $62,500. 

Defined Benefit Plan vs. Defined Contribution Plan

Most are familiar with defined contribution plans like a 401(k). You might be wondering how these accounts differ from a defined benefit plan.

This table highlights some of the differences:        

Types of Defined Benefit Plans

Defined benefit plans can take several forms, such as:

• Pension plan: The most common type of defined benefit plan is a pension. It provides guaranteed income based on years of service and final average salary. 
• Cash balance plan: Each participant has an individual “account” that grows with employer contributions at a fixed interest rate. Employees can take a lump sum or convert it to an annuity in retirement.
• Pension equity plan: In this plan, benefits are calculated based on a percentage of the final salary, multiplied by years of service. It’s generally paid as a lump sum. 
• Career average plan: Benefits are paid on the average of all earnings during an employee’s career. These funds are yielding lower benefits than final average pay plans.
• Flat benefit plan: This plan pays a fixed amount per year of service, regardless of salary. This is a simpler plan, but will yield a lower amount of funds. 
• Final average pay plan: The benefits are based on the average of the highest-earning years (often lasts three to five years). 

Advantages of Defined Benefit Plans

Wondering about the advantages of defined benefit plans? Here are five advantages:

1. Guaranteed retirement income. You receive a payout every month based on your salary, years of service and age. This predictable income helps you plan for long-term financial needs without worrying about market fluctuations.
2. Less investment stress. Since defined benefit plans are not managed by you, but by your employer, you don’t have the pressure of managing your retirement account daily. 
3. Lifetime income. Most defined benefit plans have a lifetime payout. This is automatic security as you move toward retirement. 
4. Survivor benefits. Payments will continue for a spouse or dependent after the retiree passes.  
5. Hedge against inflation Some defined benefit plans also include cost-of-living adjustments. This offers additional protection against rising costs. 

Potential Drawbacks of Defined Benefit Plans

Although lifetime income sounds like a good game plan, there are some drawbacks too. Here are some of those:

1. No choice in investments. Since a defined benefit plan is managed by an employer, you don’t have control in where funds are invested. 
2. Depends on the health of the company. Defined benefit plans are dependent on the financial stability of the company. If the company isn’t doing well, your defined benefit plan could be at risk. 
3. Inflation risk. Not all defined benefit plans account for inflation. Over time the purchasing power of the plan can be eroded by inflation. 
4. Vesting requirement. Employees have to stay a certain time at their place of employment to earn the benefits provided by a defined benefit plan. 

Who Is Eligible for a Defined Benefit Plan?

You have to meet certain eligibility requirements for a defined benefit plan. Here are the requirements: 

1. Must be employer-sponsored. You can only receive a defined benefit plan through your employer. 
2. Typically offered to full-time employees. Defined benefit plans are offered to those who are full-time employees. 
3. Employees must be vested. Generally employees need to work for employers for a specified period of time for the defined benefit plan to vest.
4. Minimum age. Some defined benefit plans require that an employee is a certain age. 

How To Maximize Your Defined Benefit Plan Benefits

You want to make certain that you maximize the benefits you receive. Here are a few ways to do so:

• Stay with your company long enough for your plan to vest. Find out the minimum time you have to stay with your employer for your benefits to vest. 
• Consider working longer. If you stay a few years longer, it can maximize your payout in terms of benefits. 
• Keep informed about your plan’s health. Stay in the loop regarding your company’s financial health and also make sure you understand any changes that can affect you if your employer makes adjustments to the plan. 
• Review your survivor and benefit choices carefully. Many defined benefit plans provide benefits to spouses and dependents after you pass. Look at your options and decide whether opting for a lower monthly payout with survivor benefits is right for your family’s financial security.

What Happens to Your Defined Plan Benefit Plan if You Change Jobs?

If you decide to change the jobs, it will have an impact on your defined benefit plan. Some things to be aware of if you switch jobs:

• Are your benefits vested? If your benefits have vested, you retain the rights to the benefits in your plan. You won’t receive any additional increases since you have switched employers. 
• Are your benefits not vested? If your benefits aren’t vested, then you won’t receive any funds from the defined benefit plan.
• Are your defined plan benefits portable? Typically your funds are not portable in a defined benefit plan. Some plans allow you to receive a lump sum payout, which you can take as a cash distribution and then roll it over into a fund of your choosing. 

Final Take

Defined benefit plans provide a dependable source of retirement income. Employees receive guaranteed benefits based on years of service and salary. Although this plan offers stability it does come with some tradeoffs. Employers are in full control of the investments If an employee switches jobs and if the benefits are not vested, they don’t receive income in retirement.

Takeaway

Finding and working with a financial advisor is a great idea. A financial advisor will help keep track of your finances and assist you in attaining your financial goals. While finding the right one can be overwhelming, you can decide to work with a financial advisor in your community or a virtual one.

Get to know your financial advisor options today for free!

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