Defined-benefit pension plans are qualified retirement plans that provide fixed and pre-established benefits to plan participants when they retire. The plans are popular with employees, who enjoy the security of fixed benefits when they retire, but they have fallen out of favor with employers, who now favor defined-contribution plans in their place, as they don’t cost employers as much money.

Nevertheless, defined-benefit plans haven’t completely gone the way of the dodo. And as they can be complex, it’s important to understand the rules mandated by the Internal Revenue Service (IRS) and the federal tax code.

Key Takeaways

  • Defined-benefit pension plans are funded by an employer from a company’s profits and generally do not require employee contributions.
  • The amount of each individual's benefits is usually linked to their salary, age, and length of employment with a company.
  • To be eligible for benefits, an employee must have a worked a set amount of time for the company offering the plan.
  • In most cases an employee receives a fixed benefit every month until death, when the payments either stop or are assigned in a reduced amount to the employee’s spouse, depending on the plan.

How a Defined-Benefit Pension Plan Works

A defined-benefit pension plan requires an employer to make annual contributions to an employee’s retirement account. Plan administrators hire an actuary to calculate the future benefits that the plan must pay an employee and the amount that the employer must contribute to provide those benefits. The future benefits generally correspond to how long an employee has worked for the company and the employee’s salary and age. Generally, only the employer contributes to the plan, but some plans may require an employee contribution as well.

To receive benefits from the plan, an employee usually must remain with the company for a certain number of years. This required period of employment is known as the vesting period. Employees who leave a company before the end of the vesting period may receive only a portion of the benefits. Once the employee reaches the retirement age, which is defined in the plan, he or she usually receives a life annuity. Generally, the account holder receives a payment every month until they die.

Companies cannot retroactively decrease benefit amounts for defined-benefit pension plans, but that doesn't mean these plans are protected from failing.

Examples of Defined-Benefit Pension Plans

One type of defined-benefit plan might pay a monthly income equal to 25% of the average monthly compensation that an employee earned during their tenure with the company. Under this plan, an employee who made an average of $60,000 annually would receive $15,000 in annual benefits, or $1,250 every month, beginning at the age of retirement (defined by the plan) and ending when that individual died.

Another type of plan may calculate the benefits based on an employee’s service with the company. In this scenario, a worker may receive $100 a month for each year of service with the company. Someone who worked for 25 years would receive $2,500 a month at their retirement age.

Variations on Benefit Payments

Each plan has its own rules on how employees receive benefits. In a straight life annuity, for example, an employee receives fixed monthly benefits beginning at retirement and ending when they die. The survivors receive no further payments. In a qualified joint and survivor annuity, an employee receives fixed monthly payments until they die, at which point the surviving spouse continues to receive benefits equal to at least 50% of the employee’s benefits until the spouse dies.

Some plans offer a lump-sum payment, where an employee receives the entire value of the plan at the time of retirement and no further payments are made to the employee or survivors. Whatever form the benefits take, employees pay taxes on them, while the employer gets a tax break for making contributions to the plan.

Defined-Benefit vs. Defined-Contribution Plans

In a defined-contribution plan, employees funds the plan with their own money and assume the risks of investing. Defined-benefit plans, on the other hand, don’t depend on investment returns. Employees know how much they can expect at retirement. The federal government does not insure defined-contribution plans, according to the Pension Benefit Guaranty Corporation (PBGC), but it currently does insure a percentage of defined-benefit plans.

Federal Tax Requirements

The IRS has created rules and requirements for employers to establish defined-benefit plans. A company of any size can set up a plan, but it must file Form 5500 with a Schedule B annually. Furthermore, a company must hire an enrolled actuary to determine its plan’s funding levels and sign Schedule B. In addition, companies cannot retroactively decrease benefits. Businesses that either do not make the minimum contributions to their plans or make excess contributions must pay federal excise taxes. The IRS also notes that defined-benefit plans generally may not make in-service distributions to participants before age 62, but such plans may loan money to participants.