Posted by Carmen Garcia

What Is a Defined Benefit Plan?

What Is a Defined Benefit Plan?

This is an employer-sponsored pension plan that offers qualified employees a guaranteed payment during retirement. This is an alternative to the defined contribution plan, which allows employees to control their contributions better and take more risks and does not guarantee a specific payment.

Defined benefit plans are out of favor because they cost employers more. However, you can still find them at government agencies, public agencies, and some for-profit companies. Here is a more detailed description of how it works and how it compares to more commonly defined contribution pension plans.

Types of defined benefit plans

There are different types of defined benefit plans. They include:

• Pensions: These provide pension income according to a predefined formula. The formula generally takes into account years of service with the employer as well as total income. When an employee reaches a certain age specified in the plan, they begin to receive payments which generally continue until their death. Some pensions also allow benefits to be transferred to a spouse or other beneficiary after the employee's death.

• Cash flow plans: guarantee employees a fixed amount when they leave the employer instead of a guaranteed monthly income. Usually, the years of work with the employer determine the amount the employee will receive.

Employers bear the investment risk with defined benefit plans and the responsibility for making and managing employee contributions. These plans differ significantly from defined contribution plans, such as 401(k), which do not guarantee that employees will receive a certain amount of retirement funds. A lifetime income earning guarantee makes defined benefit plans excellent for employees but risky for employers.

Example of a defined benefit plan

Each defined benefit plan will have its formula for calculating benefits. However, a common formula involves employers paying a fixed dollar amount, such as $100 per month in retirement funds, for each year an employee has worked for the company. This would mean that an employee who retires after working for ten years would receive a monthly retirement benefit of $1,000.

Your employer may also base your payment on your average income during working hours. If you earn $50,000 per year or about $4,167 on average, and your pension plan tells you that you will pay 20% of your average monthly income, you will receive about $833 per month.

Defined benefit plan rules

Benefit plans generally do not require employees to contribute to the plan. Instead, they are funded by the employer. However, some defined benefit plans may include voluntary contributions or employee contributions. Once employers manage and pay the contributions, they can decide who qualifies for the plan and when and how to receive payment, but they must work with the US Internal Revenue Service (IRS) and the ERISA or IRS Act.

Pension plans may have consolidation programs, such as 401(k) or other employer-sponsored pension plans that provide matching contributions. If you quit your job before you fully acquire the plan, you will lose some or all of your retirement.

Each company sets up its own rights acquisition program. However, if you think you haven't been with your employer for several years, you may be able to get more benefits from a 401(k) plan than from your company's pension plan. This is because you can contribute to 401(k), invest the funds, and get the account balance back after leaving (minus any employer contributions you haven't vested yet).

Generally, you cannot withdraw funds from the pension plan until age 65, but the exact age at which you can start distributions varies by plan. Some plans allow plan members who are not yet eligible for the distribution to borrow from their pension plan if they need the money, but, as with 401(k) loans, it is up to each employer to decide to allow it.

Your employer also determines how your benefits are distributed per ERISA (Employee Retirement Income Security Act) and IRS guidelines. Most pension plans provide a consistent monthly payment for the rest of your life. This is similar to an annuity that offers a guaranteed monthly income, but the money comes from an employer and not from an insurance company.

However, some employers give employees a fixed amount. Distribution taxes may be due, depending on how your plan is structured, so a lump sum may not be the most desirable payment method as your tax bill can go up dramatically that year.

Your employer should provide details of these and other important retirement conditions, so you know what to expect. 

Pros and Cons of the defined benefit plan

Employee defined benefit plans have several important advantages:

  • You will receive guaranteed income: you will not have to worry about depleting your investment account for your life. And, in some instances, a designated beneficiary or spouse may even have the right to continue to receive all or some of your pension after death.

  • Your employer assumes the investment risk, not you: the employer guarantees you a fixed amount and must provide it to you. If the money they contribute and invest is not enough, they still contribute to pension funds. Most pension plans also come with a federal guarantee, so you'll continue to receive pension funds if your employer can't pay as promised.

  • Your employer manages and makes contributions on your behalf: you don't have to determine how much to contribute or where to invest your pension funds.

There are also a few drawbacks:

  • Many jobs do not offer defined benefit plans: it can be difficult to find a job offer, especially in the private sector.

  • You have less power over the amount you contribute or the amount of your retirement. With a defined contribution plan or 401(k), you decide how much to invest during your career and determine your retirement plan (at the condition of respecting the retirement rules minimum distribution required). You have less control over when and how you become eligible for retirement funds or when you receive your money.

  • You may have to work for a long time for your employer to receive a significant retirement income - if you tend to change jobs, you may not benefit from all the rights in your company's pension plan or may not receive more than a small monthly amount.

Defined benefit plan vs. defined contribution plan

Defined benefit plans offer an early payment. Defined contribution plans require or allow employees and sometimes employers to make contributions up to an annual limit. The actual retirement payout depends on the amount participants choose to contribute and the performance of their investments. Well-known types of defined contribution plans include 401(k) and 403(b).

Defined contribution plans shift the burden of savings to the employee, making these retirement accounts less risky and less costly for employers. That is why the defined contribution plans have grown in popularity, while defined benefit pension plans have fallen into disrepair.

Employers can continue to contribute money to defined contribution plans, but this usually takes a corporate contribution. The employer will only contribute money if it does so first. Even so, employers usually only pay a certain amount.

Both types of plans can save you a lot of money for retirement. Some employers may allow you to have one to personally contribute to your defined contribution plan while your employer contributes to your retirement plan.

Whatever type of plan comes you are faced with at work, make sure you understand all of its rules to get the most out of it. If your business offers a retirement plan, ask them how they calculate your payment, your entitlement schedule, and whether you will receive money in a lump sum or monthly payment so you can plan accordingly.



Carmen Garcia
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