Defined-Benefit Plan

What is a 'Defined-Benefit Plan'

A defined-benefit plan is a retirement plan that an employer sponsors, where employee benefits are computed using a formula that considers factors, such as length of employment and salary history. The company administers portfolio management and investment risk for the plan. There are also restrictions on when and by what method an employee can withdraw funds without penalties.

BREAKING DOWN 'Defined-Benefit Plan'

Defined-benefit plans are also known as pension plans or qualified benefit plans. The plan is termed 'defined' because the formula for calculating the employer's contribution is known ahead of time. This fund is different from other pension funds, where the amount of payouts depends on the return of the funds invested. Therefore, if the returns from the investments set aside to fund the employee's retirement result in a funding shortfall, employers must tap into the company’s earnings to make up the difference.

Since the employer is responsible for making investment decisions and managing investments for the plan, the employer assumes all the investment risk. A tax-qualified benefit plan has the same characteristics as a pension plan but also gives the plan beneficiary additional tax incentives. However, these tax incentives are 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 benefit may be a set amount or may be calculated according to a formula that factors in years of service, age, and average salary. The employer typically funds the plan in a tax-deferred account by contributing a regular amount to the plan, usually a percentage of the employee's pay. However, depending on the plan, employees may also make contributions.

Benefits from the plan may be given as monthly payments throughout the employee’s lifetime or a lump sum payment upon retirement. In addition, some plans distribute benefits to the employee's beneficiaries upon the passing of the employee. 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, which supplies $4,500 per month to the employee.

Payment Options

Payment options commonly include a single life annuity that provides a fixed monthly benefit until death; a qualified joint and survivor annuity that offers a fixed monthly benefit until death and allows the surviving spouse to continue to receive benefits until her death; or the entire value of the plan given as a lump sum payment. Selecting the right payment option is important, because the option an employee chooses can affect the benefit amount he receives. It is best to discuss benefit options with a financial advisor.

Working an additional year increases the benefit an employee receives. Working longer increases the years of service used in the benefit formula, but it also may increase the final salary that is a factor in computing the benefit. In addition, working past the plan's normal retirement age may increase an employee’s monthly benefits.