A defined benefit plan, more commonly known as a pension plan, provides guaranteed retirement benefits to employees. Defined benefit plans are primarily funded by the employer, with pension payments based on a predefined formula that considers the employee's salary, age, and length of service.
In an age of defined contribution plans like the 401(k), defined benefit plans are becoming less common, despite the security and retirement security that pension plans can offer.
How does a defined benefit plan work?
Defined benefit plans offer similar payouts at guaranteed wages and have been offered in the past to incentivize workers to stay with the company for years or even decades.
Due to the rise of low-cost defined contribution plans, defined benefit plans are much less common today. In 1980, 83% of workers in the private sector had the option of defined benefit plans. In 2018, only 17% of workers in the private sector had this option.
The IRS treats a defined benefit plan as an employer-sponsored qualified retirement plan. This makes them eligible for benefits such as tax-deferred investment growth and tax breaks on certain contributions.
You're probably most familiar with employer-sponsored qualifying options, like a 401(k) plan. Unlike 401(k) plans, defined benefit plans are generally funded entirely by employer contributions, although in rare cases, employees may be required to pay some contributions.
How are pension benefits calculated?
The retirement benefits provided by a defined benefit plan are usually based on a formula that considers factors such as time spent with the company, salary, and age.
For example, a company may offer an annual payment of 1.5% of the average salary for each year spent with the company for the last five years of employment. If the last for 20 years, you could receive an annual benefit equal to 30% of your salary.
It is important to note that there is no single method used by defined benefit plans to calculate employee benefits.
The formula can be based on an employee's average salary over the last three years or the last five years at a company. It could also be based on the employee's average salary over their entire career at a company, or there could be a fixed dollar benefit, such as $800 for each year an employee is with the company.
If you qualify for a pension plan, be sure to check how your benefits will be calculated.
Employers generally receive tax breaks for contributing to these plans, but they are also required to provide guaranteed payouts to beneficiaries regardless of the performance of the underlying investments in a plan.
This is one of the main differentiators between pension plans and 401(k) plans, whose future payouts are entirely dependent on the performance of unsecured investments. In addition, the benefits of most defined benefit plans are protected to some degree by federal insurance provided by the Pension Benefit Guaranty Corporation (PBGC).
Defined Benefit Plan Payout Options
When the time comes to retire, you generally receive capital or annuity payments. Deciding between the two can be difficult, especially since there are several ways to structure your pension:
Single life payment: You receive one monthly payment for the rest of your life, and if you die, your beneficiaries will no longer receive payments.
Single life with term certain: You receive a monthly payment, and if you die before the end of the specified period, your beneficiaries receive payments for a predetermined number of years.
50% joint and survivor: Upon your death, your surviving spouse will receive monthly payments for the rest of their life equal to 50% of your original pension.
100% joint and survivor: Upon your death, your surviving spouse will receive lifetime monthly payments equal to 100% of the original pension.
Adding more clauses to your annuity generally means that you will receive lower monthly payments. But if you're in good health and plan to live a long life, you'll generally get the most out of choosing annuities.
A lump sum may be the best option if you have health issues and are planning a short retirement. You can also choose to take a fixed payment and invest it or use it to purchase your own annuity.
Contribution limits for defined benefit plans
Although employees generally have little control over their benefits, there are still annual limits on defined benefit plans. In 2023, an employee's annual benefit cannot exceed 100% of their average earnings for the highest earners for three consecutive calendar years or $265,000, whichever is less. That's an increase from $245,000 in 2022.
Types of defined benefit plans
There are two main types of defined benefit plans: pension plans and cash balance plans.
Pensions
Generally, a defined benefit plan is usually taken as a pension: a guaranteed monthly benefit upon retirement, based on a formula that takes into account the worker's length of service with the company and their earnings.
In order to receive retirement benefits, employees generally must remain with the company for a certain period of time. After accumulating the required duration, an employee is considered "vested." Pension plans may have different investment requirements. For example, an employee could get a 20% buyout after a year at a company, giving him retirement payouts equal to 20% of his full pension.
Purchase programs are also an integral part of defined contribution plans. About half of 401(k) plans have some type of employer contribution accrual program.
Cash Balance Plans
Cash balance plans are defined benefit plans that provide employees with a fixed account balance upon retirement or when they leave the company rather than a fixed monthly benefit. For this reason, many people think of them as a hybrid between traditional pensions and 401(k).
Although employers always bear all the investment risks associated with the management of pension funds, they do not indefinitely guarantee the payment of benefits. Instead, you are guaranteed up to a certain cash balance.
Cash budget plans typically calculate benefits based on the total number of years of employment with a company, not just the last or highest earning period. This means some people find fewer benefits if their company switches to a cash balance plan from a retirement plan.
Employers generally calculate the cash balance based on two factors: wages receivable and interest receivable. Typically, a salary credit (e.g., 3% of the employer's salary) is credited annually to an employee's account. They'll also get an interest credit on what's in the account (usually a fixed or variable rate tied to a benchmark like the 30-year treasury bill).
Each year, participants have an annual account balance which becomes theirs upon purchase and which they receive upon leaving the company. They will usually have the option of receiving the balance as an annuity that makes regular payments over time or receiving the benefit as a lump sum that can be rolled into an IRA or retirement plan.
Defined benefit plan x Defined contribution plan
Think of defined contribution plans as the newcomer and defined benefit plans as the veteran. A defined benefit plan primarily requires employers to make all contributions substantially. In contrast, a defined benefit plan requires employees to make most contributions, although many employers may choose to make matching contributions.
Although defined benefit plans typically guarantee a monthly or fixed payment based on your salary or length of service, defined contribution plan payments are not guaranteed; they depend on employee contributions and underlying performance.
Defined benefit plans offer greater certainty of return, although higher incomes can be obtained by managing pension funds.
Defined contribution schemes are much more common than defined benefit schemes, with 43% of public, local, and private sector workers participating. Although they are no longer common in private companies, defined benefit plans are still prevalent in state and local governments, with 76% of government employees participating in a pension plan.
Defined benefit plan benefits
Better retention: Defined benefit plans can keep employees with a company for a long time while they wait to purchase and collect maximum retirement benefits.
Payments are insulated from market trends: Regardless of what the underlying investments do, the value of the employee's retirement benefit remains the same.
Possibility of spousal support: A spouse may continue to receive guaranteed payments after the death of the employee.
Reliable income: Benefits are guaranteed in a defined benefit plan, which gives employees the security of a regular salary in retirement.
Tax advantages for the employer: Employers generally receive a tax deduction for contributions to defined benefit plans.
Disadvantages of the defined benefit plan
Expensive to maintain: Because they offer guaranteed payouts regardless of market conditions, defined benefit plans are more expensive for employers than defined contribution plans.
It takes time to vest: If a company requires an employee to stay for five years to be vested and the employee leaves after three years, all the money they earned stays with the company.
Lack of portability: It can be difficult to transfer money from one plan to another when an employee changes jobs, although it may be easier with cash balance plans. This does not mean that you will not continue to receive all benefits when you retire. You will only have to research several sources of income.
No investment options: Employees have no say in where their money is spent.
There is no possibility to increase your profit: The benefit formula is the benefit formula, so an employee cannot improve their retirement allowance. Employees can contribute more money or invest more aggressively to improve their returns with defined contribution plans. Those with defined benefit plans can also increase their retirement savings by using IRAs, which will be discussed later.
How to save for retirement outside of a defined benefit plan
A defined benefit plan may not provide sufficient compensation for some employees. To determine if your pension will be sufficient for retirement, find out how much money you'll need in retirement. Consult a tax professional to help you with that.
Once you have calculated the amount needed to maintain your lifestyle, subtract your estimated payments from your defined benefit and social security plans. Then set savings goals to help you make up the difference.
Even if you have a pension, you can still save in tax-deferred accounts like traditional IRAs or after-tax accounts like Roth IRAs. For 2022, you can save up to $6,000 in an IRA or up to $7,000 if you're 50 or older. For 2023, that number will increase to $6,500, or even $7,500 if you're 50 or older.
And suppose you don't have a defined contribution plan but want some of the security it offers. In that case, you can use your defined contribution plan, like a 401(k) or 403(b), to buy an annuity that provides a stable stream of income from retirement income payments.
However, annuities are not for everyone and often require high fees or confusing and complicated contracts. Be sure to speak with a financial advisor to determine how annuities can fit into your retirement plan.
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