A defined benefit plan is a retirement plan offered by employers, ensuring eligible employees receive a fixed payout when they retire. Unlike a defined contribution plan, where employees manage their contributions and take on investment risks, this type of plan guarantees a specific retirement payout.
These days, defined benefit plans aren’t as popular because they tend to be more expensive for employers. Nevertheless, they can still be found in use by public agencies, government positions, and a few for-profit companies. Let’s delve into how this qualified retirement plan functions and how it compares to the more prevalent defined contribution retirement plans.
Types of defined benefit plans
There are various kinds of defined benefit plans, and here are a few:
- Pensions: These plans calculate your retirement income using a predetermined formula. Usually, this formula considers the number of years you’ve worked for your employer and your total earnings. When you reach a certain age specified by the plan, you start getting regular payments, which typically continue until you pass away. Some pensions even allow these benefits to transfer to your spouse or another beneficiary after you’re no longer here.
- Cash balance plans: In these plans, you’re guaranteed a specific amount of money when you leave your job, instead of a fixed monthly income. The amount you receive is often based on the years you’ve spent working for your employer.
With defined benefit plans, employers bear the investment risk, and they’re responsible for handling and managing employee contributions. These plans stand in contrast to defined contribution plans like 401(k)s, which don’t promise a specific amount of money upon retirement. While the lifetime income guarantee of defined benefit plans can be appealing to employees, it also poses a financial risk for employers.
Example of a defined benefit plan
Each defined benefit plan has its unique way of calculating the benefits you’ll receive when you retire. However, a common method involves employers contributing a fixed amount, like $100 each month, to your pension for every year you’ve worked at the company. So, if you retire after a decade of service, you’d get $1,000 every month from your pension plan.
Alternatively, your employer might calculate your payout based on your average income throughout your employment. For instance, if your yearly earnings were $50,000, which averages to around $4,167 per month, and your pension plan promises to provide 20% of your average monthly income, you’d receive approximately $833 each month in retirement.
Defined benefit plan rules
Defined benefit plans typically don’t ask employees to chip in money; it’s the employer who foots the bill. Nevertheless, a few of these plans might let employees make voluntary or mandatory contributions. Since employers handle the contributions, they also call the shots on who qualifies for the plan and when and how you receive your retirement payouts. Of course, they need to follow the rules laid out by the U.S. Internal Revenue Service (IRS) and the Employee Retirement Income Security Act of 1974 (ERISA).
Now, these pension plans can have what’s called “vesting schedules,” similar to what you find in 401(k) plans or other retirement schemes where employers offer matching contributions. If you decide to leave your job before you’re fully vested in the plan, you might lose some or all of the pension benefits you’ve earned.
Every company creates its own vesting schedule, but if you don’t see yourself sticking with your employer for many years, a 401(k) plan could potentially be more advantageous. With a 401(k), you can put in your own money, invest it, and take your account balance with you when you leave (minus any employer contributions that haven’t fully vested yet).
Normally, you can’t take money out of your pension plan until you reach 65, but the specific age when you can start getting payments differs from one plan to another. Some plans let you borrow from your pension if you need some cash before you’re eligible for regular payouts, but this, like 401(k) loans, depends on your employer’s rules.
The way your employer gives you the money from your pension is also decided by them, as long as they follow IRS and ERISA rules. Most pension plans offer a steady monthly payment that lasts for your whole life. Think of it like an annuity that guarantees you a monthly income, but instead of an insurance company, it’s your employer footing the bill.
However, some employers choose to give you all the money at once in a lump sum. Depending on how your plan is set up, you might have to pay taxes on these payouts, and this could significantly increase your tax bill for the year.
Your employer should provide you with information about these and other important pension terms so you’re not in the dark about what to expect. If you have questions about the plan, your company’s HR department is the place to go for answers.
Advantages and Disadvantages of Defined Benefit Plans
There are some great perks that come with defined benefit plans for employees:
- Guaranteed Income: With these plans, you can count on a steady income without worrying that your savings will run out as you grow older. Plus, in certain situations, your spouse or chosen beneficiary may continue to receive part or all of your pension even after you’re gone.
- Less Investment Risk for You: Your employer is the one taking the financial risks, not you. They promise to provide you with a specific amount of money, and it’s their responsibility to deliver on that promise. Even if their contributions and investments fall short, they still have to make sure your pension funds are there. Many pension plans are also protected by a federal safety net, so you’ll still get your pension even if your employer can’t fulfill their commitment.
- Employer Handles Everything: You don’t have to stress about how much to save or where to invest your retirement money. Your employer manages your retirement contributions and makes sure they’re taken care of. It’s a hands-off approach that can simplify your financial planning.
However, there are also some downsides to consider:
- Limited Availability: Many jobs, especially in the private sector, don’t offer defined benefit plans. So, it can be quite challenging to find a job that provides this kind of retirement benefit.
- Less Control Over Contributions and Payouts: Unlike a 401(k) or other defined contribution plans where you have a say in how much you save over your career and when you withdraw your money (as long as you follow the rules), defined benefit plans give you less control. You don’t get to decide when you become eligible for pension funds or when you receive your payments.
- Long-Term Commitment Required: To receive a substantial pension income, you often need to work for your employer for a long time. If you tend to switch jobs frequently, you might not fully vest in your company’s pension plan, or you may end up with only a small monthly pension amount.
Defined benefit plan vs. defined contribution plan
- Defined Benefit Plans: These plans promise you a set amount of money when you retire. It’s like a guaranteed paycheck for your retirement.
- Defined Contribution Plans (like 401(k) or 403(b)): With these plans, you and sometimes your boss can put money in, but there’s a limit to how much you can add each year. What you end up with when you retire depends on how much you save and how well your investments do. It’s kind of like saving for the future and investing your money.
- Now, here’s the key difference: Defined contribution plans put more of the responsibility on you to save for retirement. This makes them less risky and cheaper for employers. That’s why they’ve become more popular recently, while defined benefit pension plans have become less common.
Sometimes, employers still pitch in money to defined contribution plans, usually as a “match.” This means they’ll add money only if you do, and there’s usually a limit to how much they’ll contribute.
Both these retirement plans can be useful for saving money as you prepare for retirement. In some cases, your employer might even let you have both types, so you can put your own money into a defined contribution plan while your employer adds to your pension plan.
Regardless of which plan you’re offered at work, it’s important to know all the rules to make the most of it. If your company provides a pension plan, make sure to ask about how they figure out how much you get, the schedule for when you become fully entitled to it, and whether you’ll receive it all at once or in monthly payments. This way, you can plan your retirement more effectively.
