What Is a Defined Benefit Plan? | Retirement

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Defined benefit plans are often referred to as pensions. For employees who meet certain criteria in the workplace, these accounts typically pay out predetermined benefits in retirement.

Here’s a look at defined benefit plans and how retirees can make the most of them.

What Is a Defined Benefit Plan?

“A defined benefit plan is a type of pension plan that is fully funded by employer contributions and is a promise to pay benefits at retirement based on various factors such as age, salary and years of service with the company,” says Valerie McClendon, a financial advisor at Boston Wealth Strategies.

What Is a Defined Benefit Pension Plan?

By and large, a defined benefit pension plan is the same as a defined benefit plan.

“As a defined benefit plan is a type of employer-sponsored retirement plan that provides a specific, predetermined benefit to eligible employees upon retirement, you might also hear it called a defined benefit pension plan,” says Eliza Arnold, co-founder and CEO of Arnie, a full-service 401(k) plan provider in San Francisco. “Like any defined benefit plan, a defined benefit pension plan’s benefit amount is typically based on an employee’s salary history, years of service and a specific formula determined by the plan.”

Is a 401(k) a Defined Benefit Plan?

No. A 401(k) is a defined contribution plan. In the employer-sponsored retirement plan sector, it is one of two plan platforms allowed under U.S. federal government regulations: defined benefit plans and defined contribution plans.

“The reason these are called defined contribution plans again is right in the name – it’s the contribution deposited each year that is known,” McClendon says. “The plan participant, however, has no idea what that money will grow to at retirement. That will depend on the investment performance of the funds.”

Defined Benefit Plans vs. Defined Contribution Plans

Some key differences between defined benefit plans and defined contribution plans:

  • The limits allowed in defined benefit plans are much larger than those allowed in 401(k) plans.
  • Defined benefit plans are fully funded by the employer, “where 401(k) plans (or defined contribution plans) are funded by both the employees and the employer,” McClendon says.
  • With a defined benefit plan, the benefit is calculated taking into account factors such as salary, years working for the company and age, which differs from 401(k)s.

“If you added 6% into a 401(k), you would have a value over time, but that value doesn’t necessarily turn into a predictable income stream,” says Andrew Creme, a financial advisor at Creme Wealth Team in Frisco, Texas.

If the 6% were going into a pension, the terms may be generally described as follows, Creme says:

  • Employees put 6% of their salary into the pension plan.
  • After 20 years of service working for the company and attaining a minimum age of 55, the employee can receive a benefit equal to 50% of the average of their highest five years of employment.
  • If an employee was earning $100,000 on average when she retired, she would be eligible to receive $50,000 per year for the rest of her life after retirement.

“All defined benefit plans are contracts between employees and employers, so they can have differences,” Creme says. “In general, the benefits on a defined benefit plan are determined by pay, years of service with the company and age.”

How Defined Benefit Plans Work

Defined benefit plans are established by an employer to benefit employees, and they operate on a thorough formula and unique asset-holding strategy.

“The amount of an employee’s benefit is determined by a formula established in the plan,” says John Lowell, an Atlanta-based partner at October Three Consulting in Chicago. “In most cases in the private sector, these plans are entirely paid for by the employer. That’s not the case in the governmental sector, where there are usually mandatory employee contributions as well as those an employer makes.”

The assets in a defined benefit plan are held in a trust, and the employer controls that trust, Lowell says. “While an employee has a right to a benefit from the plan, there is no specific amount of assets or any particular asset in the trust that belongs to a particular employee,” Lowell says.

When an employee reaches retirement age, “that employee will typically receive some form of guaranteed lifetime income from the plan that might also pay certain additional benefits to their spouse or other designated beneficiary,” Lowell says.

How Are Pension Benefits Calculated?

Pension benefits are calculated according to a plan formula that is specific to that plan and specified in the formal plan document.

“Usually, the key components of that calculation are the number of years that an employee was in the plan and their compensation, often over the years in which that compensation was highest,” Lowell says.

Plan benefits may also be calculated by evaluating your most recent salary history, age and years of service with the company.

“There can be multiple options in defined benefit plan payout calculations, such as a monthly benefit payment with a portion payable to a beneficiary, a 10-year certain (annuity), a five-year certain or a life-only payment with no beneficiary,” says Annette Harris, owner of Harris Financial Coaching in Jacksonville, Florida. “Selecting a beneficiary who will receive a portion of your pension benefit at the time of your death will reduce your monthly payment.”

If you opt for a life-only payment, “you’ll receive a set monthly pension benefit, and any of your survivors will be unable to receive a benefit at the time of your death,” Harris says.

What Are the Pros and Cons of Defined Benefit Plans?

One big advantage of a defined benefit plan is having a set benefit payment for the rest of your life. “It’s also helpful to your surviving beneficiary because they will be due a benefit at your death, creating financial stability,” Harris says.

One big disadvantage of a defined benefit plan is that you can’t cash it out. “You cannot draw from your retirement payment if you face financial hardship,” Harris notes. “The value of your retirement payment also remains the same.”

For example, if you’ll be retired for 20 or more years and inflation inevitably occurs, your benefit will remain the same. “This can make it challenging for retirees to survive financially when they have a set pension benefit that doesn’t take into account the cost-of-living increases,” Harris says.

Here’s how Lowell breaks down some of the pros and cons of defined benefit plans.

  • The default form of payment is guaranteed lifetime income.
  • In most nongovernmental plans, the benefit is federally guaranteed up to fairly substantial limits.
  • In most nongovernmental plans, the benefit is paid for entirely by the employer.
  • Investment risk is born by the plan, not the employee.

  • Many employees find them difficult to understand.
  • Since you don’t have a pool of assets that is yours, you generally cannot borrow against it and you often can’t get your money out until you retire.
  • Your plan might not offer a lump sum option of distribution.

Tips for Defined Benefit Plan Participants

Defined benefit plans are unique in multiple ways, and it helps to be diligent and creative when building retirement assets. Take these three action steps along the way to get the most from your retirement plan.

Stick around. Plan to work longer for a company that offers a generous defined benefit plan. “Since the amount of benefit you get is defined by a formula, it’s more about sticking with it than maximizing it,” Lowell says.

Expand your horizons. Explore opportunities to contribute to other retirement accounts, like a 401(k) or IRA, to diversify your retirement savings and maintain your control over investment decisions.

“Also, make sure you evaluate your overall retirement strategy and consider factors like health care costs, other sources of income and any potential pension benefit reductions based on retirement timing,” Arnold says.

Understand the plan’s options for payout. They may differ. “Some plans offer a lump-sum payout, while others provide a monthly annuity,” says James Allen, a certified public accountant at founder of Billpin, a financial advisory company. “The right choice depends on your personal circumstances and financial goals.”

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