A defined benefit plan is often referred to as a traditional pension. Employees who meet the criteria for the plan are typically provided with payments in retirement.
Here’s how defined benefit plans work:
— Employers often fund the defined benefit plan on behalf of employees, but some plans might require or encourage employee contributions.
— Unlike a defined contribution plan, the employer manages the investments within the pension.
— Plans use unique calculations to determine the payout an employee should receive in retirement.
— Funds could be dispersed as a lump sum or an ongoing series of payments, depending on the plan.
What Is a Defined Benefit Plan?
A defined benefit plan is a workplace retirement benefit that promises long-term employees a set payment in retirement. The retirement payment is typically calculated using your age, years of service and salary. Employers usually fund the plan, but in some cases employees also contribute.
The funds in the plan are invested and managed by the employer, which is a “very efficient and effective way to manage those retirement responsibilities with one investment advisor,” says Jonathan Price, a senior vice president and national retirement practice leader at Segal in New York. These funds are then dispersed according to a specific formula after an employee has retired.
[Read: A Guide to Getting a Pension.]
Defined Benefit Plan Payment Options
You might have several options to receive your defined benefit plan payments in retirement. An annuity might be the best option for someone looking for consistent payments over the course of the rest of their life. You may also be able to elect to have payments continue for a surviving spouse after you pass away. Some defined benefit plans offer a lump sum payment for someone looking to invest the funds individually or make a large purchase.
Your retirement payments are calculated using a unique formula that is specific to your employer. Factors that could influence your payment include how much you made toward the end of your career and how long you worked for the company. “There are literally an infinite number of formulas that could be used, and in practice defined benefit plans are all very different,” says Matt McDaniel, a partner and U.S. financial strategy group leader at Mercer in Philadelphia. “Some are based on average pay. Some are based on just a flat dollar amount. They can get even more esoteric. They come in all sorts of different flavors and shapes.”
Some details to look for in your plan explanation include how many years of service you need to be eligible for payouts and who you can name as a recipient of benefits. Most plans will include information about whether they will make full or partial payments to a spouse, but also make sure you understand your plan’s potential payouts to other dependents, such as life partners or children, in the event that you die before you retire.
A Defined Benefit Plan Versus a Defined Contribution Plan
While both are types of employment-based retirement plans, a defined benefit plan and a defined contribution plan place the responsibility to save and invest for retirement on different people.
Under a defined contribution plan, such as a 401(k), an employee can choose how much to save and how to invest those funds. While an employer may sponsor the plan and opt to match a certain amount of contributed funds, it’s up to the individual employee to make decisions about saving and investments and manage those funds for retirement.
With a defined benefit plan, the employer takes on most of the responsibility for making contributions to the plan and managing investments. An employer choosing to offer a defined benefit plan develops a formula that codifies the payout to retired employees who meet specific criteria. Employees can examine the plan documents to find out how much the plan will pay them in retirement without having to manage the investment themselves.
A defined benefit plan generally promises a specific payout that employees who qualify for the payments can count on in retirement. “The defined benefit plan typically has a more structured payout in retirement,” Price says. In comparison, the exact financial compensation an individual will receive from their defined contribution plan is less clear and depends on how the individual account owner saves and invests. “The benefit at retirement may have more flexibility or uncertainty with a defined contribution plan,” Price says.
You will likely have to pay income tax on both types of retirement benefits in retirement. “Both defined benefit plans and defined contribution plans, with the exception of Roth (IRA) contributions among the defined contribution plans, all of those benefits are taxed when you receive them, so there is a tax deferral advantage that exists in both types of plans,” McDaniel says.
[See: Jobs That Still Offer Traditional Pensions]
Advantages of a Defined Benefit Plan
Relatively few private sector employers continue to offer both defined benefit plans and defined contribution plans. Within the private sector, only 15% of employees have access to a defined benefit plan, according to a 2021 Congressional Research Service report. By comparison, a significantly higher number of public sector workers at the state and local level (86%) were able to access a defined benefit plan.
“It is a distinct minority of employers that currently offer a defined benefit plan to new hires,” McDaniel says. “For somebody starting at a new company today, odds are your new company is only going to offer a defined contribution plan, with the exception of a relatively small percentage that still offer (defined benefit) plans.”
If you are among the few employees who still have a choice to tap into both a defined benefit plan and a defined contribution plan, understand your appetite for risk and desire to actively supervise your own investments before making a selection. When an employer offers a defined benefit plan, “the employer rather than the employee is taking all of the investment risk, longevity risk, interest rate risk, all of those sorts of things,” McDaniel says. “Whereas with a defined contribution plan, that all sits with the employee.”
Disadvantages of a Defined Benefit Plan
Defined benefit plans tend to provide the biggest payouts to long-term employees. If you leave a company that was contributing to a defined benefit plan in your name, you won’t lose your accrued benefits, assuming your benefits have vested, meaning you have reached the specified time period that makes you eligible to receive the compensation. However, your retirement payments may not amount to much if you change employers frequently and don’t stay with the same employer for many years. “One of the features of defined benefit plans is they tend to be very backloaded,” McDaniel says. The benefits you accrue in the first few years of employment with a company generally won’t be as substantial as those earned by those just a few years shy of retirement.
If you want more control over how your retirement savings is invested or plan to change jobs frequently, you might prefer a defined contribution plan. “I would say a lot of it has to do with personal preference,” McDaniel says. “If you’re the type of employee who is really comfortable making investment decisions and managing your own finances and would be comfortable getting one big lump sum of money at retirement that you’ll then spend down and manage, a defined contribution plan might be more your style.”
[Read: How Pension Income Is Taxed]
What Happens to a Pension if the Company Goes Bankrupt?
Companies that sponsor defined benefit plans are required to properly fund the plan, so there should be enough funds to pay out your retirement benefit. Additionally, the Pension Benefit Guaranty Corporation is a federal agency that insures most private sector pensions. “The PBGC may take over a plan for various distressed reasons,” Price says. “And when the PBGC takes over a plan, they’ll maintain the records of knowing who is entitled to a benefit currently and in the future, and then they will take custodial responsibility to pay out those benefits.”
The PBGC will continue payments to participants in failed pension plans up to certain annual limits. “If you have very high benefits, there’s a chance you might take a little bit of a haircut, but (the agency is) a pretty strong protection,” McDaniel says.
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What Is a Defined Benefit Plan? originally appeared on usnews.com
