A defined benefit plan is often referred to as a traditional pension plan. Employees who meet the plan’s criteria generally receive payments upon retirement.
Here’s how defined benefit plans work:
- Employers often fund the defined benefit plan on behalf of employees, but some plans may require or encourage employee contributions.
- Unlike a defined contribution plan, the employer manages the investments within the pension plan.
- The plans use unique calculations to determine the payout an employee should receive upon retirement.
- The funds could be distributed as a lump sum or an ongoing series of payments, depending on the plan.
What is a defined benefit plan?
A defined benefit plan is a workplace retirement benefit that promises long-serving employees a fixed payment in retirement. The retirement payment is usually calculated based on your age, years of service and salary. Employers usually fund the scheme, but in some cases employees also contribute.
Plan funds are invested and managed by the employer, which is “a very efficient and effective way to manage these retirement responsibilities with a single investment advisor,” says Jonathan Price, senior vice president and national practice leader. pension at Segal in New York. York. These funds are then distributed according to a specific formula after an employee retires.
Defined Benefit Plan Payout Options
You have several options for receiving payments from your defined benefit plan upon retirement. An annuity might be the best option for someone looking for regular payments throughout their life. You can also choose to continue payments for a surviving spouse after your death. Some defined benefit plans offer a lump sum payment to someone looking to invest the funds individually or make a large purchase.
Your pension payments are calculated according to a unique formula specific to your employer. Factors that could influence your payout include how much you earned towards the end of your career and how long you worked for the company. “There are literally an endless number of formulas that could be used and, in practice, defined benefit plans are all very different,” says Matt McDaniel, partner and head of the US financial strategy group at Mercer in Philadelphia. . “Some are based on the average salary. Some are based on a flat dollar amount. They can become even more esoteric. They come in all kinds of different flavors and shapes.
Some details to look for in your plan explanation include the number of years of service you need to qualify for the payouts and who you can designate as the recipient of the benefits. Most plans will include information about whether they will make full or partial payments to a spouse, but be sure to also understand your plan’s potential payments to other dependents, such as life partners or children, in the event that you die before retirement.
A defined benefit plan versus a defined contribution plan
In a defined contribution plan, such as a 401(k) plan, an employee can choose how much to save and how to invest those funds. Although an employer can sponsor the plan and choose to match a certain amount of contributed funds, it is up to the individual employee to make savings and investment decisions and manage those funds for retirement.
With a defined benefit plan, the employer takes on most of the responsibility for making contributions to the plan and managing the investments. An employer who chooses to offer a defined benefit plan develops a formula that codifies the payment to retired employees who meet specific criteria. Employees can view plan documents to find out how much the plan will pay them at retirement without having to manage the investment themselves.
A defined benefit plan typically promises a specific payout that eligible employees can count on in retirement. “The defined benefit plan generally has a more structured payout at retirement,” Price says. In comparison, the exact financial compensation an individual will receive from their defined contribution plan is less clear and depends on how the individual account holder saves and invests. “The benefit at retirement may have more flexibility or uncertainty with a defined contribution plan,” says Price.
You will likely have to pay income tax on both types of retirement benefits upon retirement. “Defined benefit plans and defined contribution plans, with the exception of Roth contributions (IRA) among defined contribution plans, all of these benefits are taxed when you receive them, so there is a tax deferral benefit that exists in both types of diets,” McDaniel says.
Benefits of a Defined Benefit Plan
Relatively few private sector employers continue to offer both defined benefit and defined contribution plans. In the private sector, only 15% of employees have access to a defined benefit plan, according to a 2021 Congressional Research Service report. In comparison, significantly more public sector workers at the state and local levels (86% ) were able to access a defined benefit plan.
“It’s a distinct minority of employers who currently offer a defined benefit plan to new hires,” McDaniel says. “For someone starting out in a new business today, chances are your new business will only offer a defined contribution plan, with the exception of a relatively small percentage who still offer schemes (defined benefit).”
If you are one of the few employees who still have the choice of taking advantage of both a defined benefit plan and a defined contribution plan, understand your appetite for risk and your desire to actively monitor your own investments before make your choice. When an employer offers a defined benefit plan, “the employer rather than the employee assumes all of the investment risk, longevity risk, interest rate risk, all those sorts of things,” McDaniel says. “While with a defined contribution plan, it’s all about the employee.”
Disadvantages of a Defined Benefit Plan
Defined benefit plans tend to provide the largest payouts to long-term employees. If you leave a company that was contributing to a defined benefit plan on your behalf, you will not lose your accrued benefits, assuming your benefits have been vested, meaning you have reached the specified period of time that makes you eligible to receive compensation. However, your retirement payments may not be high if you change employers frequently and don’t stay with the same employer for many years. “One of the characteristics of defined benefit plans is that they tend to be very retroactive,” says McDaniel. The benefits you accrue during the first few years of employment with a company will generally not be as substantial as those earned by those who are a few years away from retirement.
If you want more control over how your retirement savings are invested or if you plan to change jobs frequently, you may prefer a defined contribution plan. “I would say it has a lot to do with personal preference,” McDaniel says. “If you’re the type of employee who’s really comfortable making investment decisions and managing your own finances, and you’d be comfortable receiving a large amount of money in retirement that you’ll spend then and you manage, a defined contribution plan might be more your style.
What happens to a pension if the company goes bankrupt?
Companies that sponsor defined benefit plans are required to properly fund the plan, so there should be enough funds to pay your retirement benefits. Additionally, the Pension Benefit Guaranty Corporation is a federal agency that insures most private sector pensions. “The PBGC can support a plan for various distress reasons,” Price says. “And when the PBGC takes over a plan, it will keep records of who is entitled to a benefit now and in the future, and then it will take responsibility for paying those benefits.”
PBGC will continue to make payments to participants in bankrupt pension plans up to certain annual limits. “If you have very high benefits, there’s a chance you’ll take a little haircut, but (the agency is) pretty strong protection,” McDaniel says.