A defined-benefit plan, commonly known as a traditional pension plan, is a retirement plan funded by an employer that calculates employee benefits based on a formula that takes into account several factors, including age, employee’s salary, and length of employment.
Defined-benefit pension plans, which still exist in some public-sector jobs, were common in the private sector up until about 40 years ago. As time passed, most companies found maintaining a defined-benefit plan too costly. Currently, only 15% of private-sector workers have access to a defined-benefit plan, according to the U.S..Bureau of Labor Statistics (BLS).
Interestingly, in October 2023,, investment bank JPMorgan said that, due to many positive aspects, the defined-benefit plan should be revisited. Here’s how these plans are organized and how they compare to the defined-contribution plans that have largely replaced them.
How a defined-benefit plan works
The term “defined-benefit plan” is derived from the fact that you and your employer both know and understand the formula for calculating your retirement benefits. These plans offer guaranteed payments on a par with salaries and are offered to make it more attractive for you to stay with the employer for a long period of time. How much you should get from a defined-benefit plan depends on your tenure with the employer, salary, and age.
Every year your employer determines the amount of the future pension payments that would be made from the plan, allowing the policy to calculate the amount that needs to be contributed to fund the projected pension. You must work for a certain period of time before becoming eligible for a defined-benefit plan after retirement. This period is known as the “vesting period.”
Examples of defined-benefit plan payouts
Your employer typically funds the plan by making regular contributions, usually a percentage of your pay, into a tax-deferred account. Upon retirement, you may receive monthly payments throughout your lifetime or a lump sum.
For instance, if you have 40 years of service at the time of your retirement, the benefit may be specified as an exact amount of $200 per month per year. You would receive $8,000 per month in retirement under this plan. Some plans distribute the remaining benefits to your beneficiaries upon your death.
Defined benefit plan: Pros and cons
Pros:
Guaranteed income after retirement.
Money is safe.
Employer gets tax benefits.
In case of death, spouse gets payments.
Employee retention.
Cons:
Lack of investment options.
Portability issue.
Must wait to fulfill the vesting period.
Can’t increase your benefit.
Costly for employer.
Advantages
Guaranteed income after retirement. A defined-benefit plan provides you with the security of a guaranteed paycheck after retirement.
Money is safe. Investment performance does not affect retirement benefits, and your money is safe regardless of market fluctuations.
Employer gets the tax benefits. Defined-benefit plans generally provide tax deductions for employers.
In case of death, your spouse gets payments. After your death, your spouse may continue to receive guaranteed payments.
Employee retention. A pension program that offers a guaranteed sum of money upon retirement increases employee retention. As a result, employees are more likely to feel satisfied with their jobs and remain loyal to their companies.
Disadvantages
Lack of investment options. It is up to the company to decide where its money is invested. The choice is made without your input.
Portability issue. While cash balance plans may make it easier for employees to move money between plans as they change jobs, traditional pension plans are a bit challenging to import. Nevertheless, a financial concierge app named “Beagle” takes care of the whole rollover process and can help you find lost savings.
Must wait to fulfill the vesting period. If you leave the company after two years and the vesting period is five years, all the money you earned stays with the company.
Can’t increase your benefit. A defined-benefit pension pays a fixed income upon retirement; there is no way for you to increase your retirement income from that plan.
Costly. Your employer contributes to the plan, manages investments, pays out benefits, and handles other administrative tasks. The maintenance of defined-benefit plans can be costly, one reason why employers find them more expensive.
Types of defined-benefit plans
Defined-benefit plans fall into two categories. These are:
Pensions. A defined-benefit plan is often thought of as a pension because it guarantees a monthly income upon retirement based on a predefined formula. A certain length of service with a company is usually required to qualify for pension benefits. Upon death, some pensions allow your beneficiaries to receive benefits as well.
Cash balance plans. An employee with a cash balance plan, on the other hand, receives a set amount of money at retirement or when they leave their company, rather than a set amount of money each month. When their companies switch from pension plans to cash balance plans, some people end up with fewer benefits, because the benefits are calculated based on their total working years with the company. Pay and interest credits are the two most common methods employers use to determine the cash balance.
How are pension benefits calculated?
There is no single method for calculating defined-benefit plans. It could be based on a certain percentage of earnings, the employee’s average salary, or an agreed-upon specific amount. Ultimately, it depends on how each business decides which plan to choose and how much they are willing to spend. A few of them are:
Average earnings benefit. The benefit is calculated by multiplying a certain percentage of the average monthly earnings by the number of years worked for the company.
Final earnings benefit. The benefit can be calculated by multiplying the defined percentage of average monthly earnings over the last five years by the number of years worked.
Flat benefit. Calculation of the benefit is based on multiplying a defined dollar amount by the number of years of service.
Defined-Benefit Plan Payment Options
Defined-benefit plans generally allow you to specify how you wish to receive your benefits. Payment options can affect the amount you get, so choosing the right one is important. There are two types of payouts: annuities and lump sums.
Annuity payments
With annuity payments, a retired employee gets a steady income for the rest of their life. Know about these two types: A single-life annuity provides a fixed monthly benefit for your lifetime. Or, if the plan allows it and you have a partner, you might opt for a qualified joint and survivor annuity. Under this type, you get a fixed monthly benefit until death. If you die first, your surviving spouse continues to receive benefits. (The monthly benefit may be lower under this type of plan than for a single-life annuity.)
Note that if a retiree dies early and there is no surviving spouse, they likely won’t have received enough payments to collect all that they were eligible to receive. Usually, the pension doesn’t pay anything to beneficiaries except through a joint and survivor plan.
Lump-sum payments
In a lump-sum payment, the retired employee gets the entire value of the plan in a single payment. With a lump-sum payment, you can invest the money to earn the income—or use some of it to pay off large debts or, for example, the balance on a mortgage. Any money you don’t spend is available to your heirs. However, if your retirement money is not managed properly—or the lump sum is modest—it may not last for the rest of your life.
Defined-benefit plan vs. defined-contribution plan
There are a number of key differences between defined-benefit plans and defined-contribution plans:
Who contributes. Defined-benefit plans require your employer to make nearly all contributions, while defined-contribution plans require most of the contributions be made by you, though your employer has the ability to choose to match your contributions.
Who manages the funds. With a defined benefit plan, your employer manages the funds; in a defined contribution plan, you do.
Certainty about benefits. This is one of the most important contrasts.
Defined-benefit plan. As the term states, once you vest in one, you know what your benefit will be at retirement, given your salary and years of service. Single-employer and multiemployer plans are protected by a federal agency, the Pension Benefit Guaranty Corporation, which will step in to pay your benefits if your plan terminates without sufficient funding, up to the amounts guaranteed by law.
Defined-contribution plan. Payouts aren’t guaranteed and are dependent on employee contributions and investment performance. However, the money you contribute to a defined-contribution plan is always yours; you don’t have to vest in it. (To get employer matching funds, if your employer offers them, you do have to meet vesting requirements, unless your employer offers immediate vesting.)
Tax breaks. Depending on which plan you choose, you get tax advantages for your contributions to a defined-contribution plan. Your employer gets the benefits for a defined-benefit plan.
Availability. As noted earlier, defined-contribution plans are much more popular with private employers than defined-benefit plans. The vast majority of state and local governments still provide defined-benefit plans.
Alternatives to savings with a defined-benefit plan
Until about 40 years ago. was common for employees to participate in defined-benefit pension plans. As time has passed, most companies have determined that maintaining a defined-benefit plan is too costly. Currently, only 15% of private-sector workers have access to a defined-benefit plan, according to the U.S..Bureau of Labor Statistics (BLS).
There are many alternatives to defined-benefit plans. They include:
401(k)
A 401(k) is a defined-contribution plan, meaning that you, the employee, make the contributions to the plan if you choose to. There are two types of 401(k) plan—traditional and designated Roth accounts. Both offer tax-free growth of your investments. Traditional 401(k)s offer tax deductions for contributions; Roth 401(k) contributions are made with post-tax income but provide tax-free qualified withdrawals at retirement.
By enrolling in a 401(k), you agree to have a percentage of each paycheck deposited directly into an investment account. A portion or all of that contribution may be matched by your employer.
IRAs
An individual retirement account (IRA) is a long-term savings vehicle that allows anyone with earned income to save for retirement. In contrast to a 401(k), which is only available through employers, any qualified earner can open an IRA. For 2024 you can contribute up to $7,000 per year to a traditional or Roth IRA—$8,000 if you are age 50 or older. You have a choice of opening a traditional IRA or (if you meet the income requirements), a Roth IRA. Contributions to a traditional IRA generally provide a tax deduction (with some limitations) and those to a Roth are made with after-tax income, but are tax-free at retirement. [Actually, until tax-filing date—April 15, 2024, for most people—you can still also make a 2023 contribution ($6,500/$7,500) if you haven’t already done so.]
Other investments
You can choose from a variety of investments with minimal tax implications, such as mutual funds and municipal bonds. Investing in real estate through platforms such as RealtyMogul is also an option.
TIME Stamp: The era of the defined-benefit plan is over
After you retire, a defined-benefit plan will pay you a guaranteed sum at a regular interval from money set aside by your employer—regardless of how well the employer’s pension plan investments have done.
By contrast, a defined-contribution plan holds money that you have contributed during your working life, and that money is subject to investment fluctuations. Other than required minimum distributions, currently starting at age 73 for most people, you determine how much you withdraw from a defined-benefit plan and at which intervals. You can also choose to put some or all of your fund into an annuity, which will pay a regular income similar to a pension fund. Check the rules—and fees—carefully before you choose this route. And unlike an employer pension, insurance companies that provide annuities are not covered by the Pension Benefit Guaranty Corporation. Research very carefully any place from which you are considering purchasing an annuity.
This is pretty much why defined-benefit plans have become a thing of the past: They are much less expensive for an employer, and you take the market risk, not your employer.
Selecting the right retirement plan and payment option can have a significant impact on your benefit amount. The best way to learn about benefit options and retirement planning in general is to speak with a financial advisor. One reputable possibility is Empower, America’s second-largest provider.
The amount of an annuity may not completely cover all costs in retirement. Planning for retirement should include factoring in Social Security benefits and other retirement savings.
Frequently asked questions (FAQs)
What is the main difference between a 401(k) and a defined-benefit plan?
The main difference between a defined-contribution 401(k) plan and a defined-benefit pension plan is who pays into it. Employees are on the hook for the former (though employers have the option to match their contributions), while employers must foot the bill for the latter.
Defined-benefit plan vs. 401(k): Are there other differences?
Yes, there are. Employers decide the terms of a defined-benefit plan and how it’s invested; employees have no say in it. However, 401(k) investments are controlled by employees, who can make choices about how their plan money is invested. Also, a defined-benefit plan provides a regular guaranteed income for life, whereas 401(k) benefits vary. Poor investments can reduce income flow, and withdrawals from the plan deplete its principal. Of course, 401(k)s can also be enhanced through good investments. Pension plans are static.
How do you set up a defined-benefit plan?
In order to set up a defined-benefit plan, employers need a plan document issued by an actuary or administrator that has been preapproved by the Internal Revenue Service (IRS). To report on the plan to the IRS, employers are required to file Form 5500 every year. Additionally, Schedule SB should be signed by the actuary and attached to Form 5500.
