What Is a Defined-Benefit Plan?
A defined-benefit plan is an employer-sponsored retirement plan where employee benefits are computed using a formula that considers several factors, such as length of employment and salary history. The company administers portfolio management and investment risk of the plan. There are also restrictions on when and by what method an employee can withdraw funds without penalties. Benefits paid are typically guaranteed for life and rise slightly to account for the increased cost of living.
Understanding Defined-Benefit Plan
Also known as pension plans or qualified-benefit plans, this type of plan is called "defined benefit" because employees and employers know the formula for calculating retirement benefits ahead of time, and they use it to define and set the benefit paid out. This fund is different from other retirement funds, like retirement savings accounts, where the payout amounts depend on investment returns. Poor investment returns or faulty assumptions and calculations can result in a funding shortfall, where employers are legally obligated to make up the difference with a cash contribution.
- A defined-benefit plan is an employer-based program that pays benefits based on factors such as length of employment and salary history.
- Pensions are defined-benefit plans.
- In contrast to defined-contribution plans, the employer, not the employee, is responsible for all of the planning and investment risk of a defined-benefit plan.
- Benefits can be distributed as fixed-monthly payments like an annuity or in one lump-sum payment.
- The surviving spouse is often entitled to the benefits if the employee passes away.
Since the employer is responsible for making investment decisions and managing the plan's investments, the employer assumes all the investment and planning risks. A tax-qualified benefit plan has the same characteristics as a pension plan, but it also gives the employer and beneficiaries additional tax incentives not available under non-qualified plans.
Examples of Defined-Benefit Plan Payouts
A defined-benefit plan guarantees a specific benefit or payout upon retirement. The employer may opt for a fixed benefit or one calculated according to a formula that factors in years of service, age, and average salary. The employer typically funds the plan by contributing a regular amount, usually a percentage of the employee's pay, into a tax-deferred account. However, depending on the plan, employees may also make contributions. The employer contribution is, in effect, deferred compensation.
Upon retirement, the plan may pay monthly payments throughout the employee’s lifetime or as a lump-sum payment. For example, a plan for a retiree with 30 years of service at retirement may state the benefit as an exact dollar amount, such as $150 per month per year of the employee's service. This plan would pay the employee $4,500 per month in retirement. If the employee dies, some plans distribute any remaining benefits to the employee's beneficiaries.
Annuity vs. Lump-Sum Payments
Payment options commonly include a single-life annuity, which provides a fixed monthly benefit until death; a qualified joint and survivor annuity, which offers a fixed monthly benefit until death and allows the surviving spouse to continue receiving benefits thereafter; or a lump-sum payment, which pays the entire value of the plan in a single payment.
Selecting the right payment option is important because it can affect the benefit amount the employee receives. It is best to discuss benefit options with a financial advisor.
Working an additional year increases the employee's benefits, as it increases the years of service used in the benefit formula. This extra year may also increase the final salary the employer uses to calculate the benefit. In addition, there may be a stipulation that says working past the plan's normal retirement age automatically increases an employee's benefits.