Understanding Defined-Benefit Pension Plan
A defined-benefit plan is a retirement option where the benefits paid on retirement are calculated using a fixed formula. The formula is typically based on the employee’s salary history and the number of years of employment. These plans differ from a 401(k) or a defined-contribution plan. For a defined-contribution plan, the employer and the beneficiary make ongoing payments into a retirement account, and the benefits paid to depend on the investment earnings accumulated in the account. For a defined-benefit plan, the employer contributes most of the funds.
How Does a Defined-Benefit Plan Work?
A defined-benefit plan gives the employer a fixed benefit when they retire that is not dependent on an accumulated investment and the return on that investment from the market. Therefore, it could be considered a safer savings option. From the employer, these types of plans are the most expensive and are complex to administer. The employer must contribute most or all of the money; however, they can also deduct more from their tax obligations. In some cases, employee contributions are required, or voluntary contributions are permitted. The employer shoulders most of the financial responsibility for a defined-benefit plan. The employer must ensure that there are sufficient funds to pay the benefits to the employee when the time comes, regardless of the performance of the investments. An employee may be required to complete a specific number of years before they qualify for any benefits. This is the same for any retirement plan. However, with a defined-benefit plan, the vesting period may be much shorter than it would be with a defined-contributions plan. Beneficiaries do not have to pay tax on contributions until they start to receive distributions. At that point, beneficiaries must comply with the Employee Retirement Income Security Act of 1974 (ERISA) and the Internal Revenue Code.
Advantages of a Defined-Benefit Plan
- An employee can accrue substantial benefits in a short period, unlike a defined-contribution plan that takes time to accumulate funds.
- Employers mostly contribute to these types of plans. They can also deduct more from their tax obligations than they would with other types of retirement plans.
- The employee knows how much they will receive in benefits.
- Vesting periods can vary from immediate vesting to terms up to seven years.
- Employers can offer early retirement benefits.
- Retirement benefits are not dependent on the stock market.
Disadvantages of a Defined-Benefit Plan
- For the employer, this type of plan is the most complex and the most costly to establish.
- The employer shoulders most of the financial responsibility.
- An excise tax applies if minimum contribution requirements are not satisfied or if excess contributions are applied.
How Are the Benefits Calculated?
The benefits for a defined-benefit plan are calculated with a set formula. That formula could be based on an amount paid for each year an employee has worked for an employer or a percentage of earnings. Some plans average the employee’s earnings during the last few years of employment or over the total employment period, take a percentage of that amount, and then multiply it by the number of years of service. Ideally, defined benefit plans should replace a certain percentage of an employee’s pre-retirement income when combined with Social Security, for example, 70 percent. Therefore, some plans will consider the Social Security benefits a retiree may receive and lower the payments accordingly.
How to Set Up and Operate a Defined Benefit Plan
The process to set up and operate a defined benefit plan begins with an assessment of goals for the plan. Several questions must be answered at this point. For example:
- What is the expected payout that employees or beneficiaries of the plan expect to receive and for how long?
- What is their current compensation and how much can the employer contribute on an annual basis to the plan?
- Are these contributions to be made in a single payment or should they be made periodically over time?
Once the plan’s broad design is in place, the actual numbers are put in and vetted, and signed by an actuary. Finally, the business’s senior management or executives sign the plan. The next step is to find a financial institution to act as a trustee for the plan’s assets. Banks and brokerages are examples of institutions approved to operate a defined benefit plan. The assets for a Defined Benefit Plan have a trust identification number assigned to them. Companies with Defined Benefit Plans are required to file Form 5500 with a Schedule B annually. The IRS defines Defined Benefit Plans as their “most administratively complex plan” because it has instituted a number of rules related to the plan’s design and functioning.
Payment Options for Defined-Benefit Plans
Most plans allow the beneficiary to choose how they will receive benefits: either a single life annuity, a qualified and joint survivor annuity, or a lump-sum payment. A single-life annuity provides the beneficiary with a fixed monthly payment until they die, but no payments are made to survivors. A qualified joint and survivor annuity provides a fixed monthly benefit until death, and the surviving spouse receives benefits (in an amount equal to at least 50 percent of the benefit) until their death. For a lump-sum payment, the plan’s value is paid in one go with no further payments to survivors. Note that the payment option that a beneficiary chooses can affect the amount they receive. Selecting the right retirement plan and payment options is not easy because there are so many factors to consider. Therefore, it is advisable to consult a financial advisor before choosing a retirement plan.
About the Author
True Tamplin, BSc, CEPF®
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide, a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.