Definition and Example of Defined Benefit Plan
A defined benefit plan is a type of retirement plan that employers offer their workers, guaranteeing them a fixed retirement income. An employer determines how much benefit each employee is eligible for based on their average salary and their years of employment. Then, the employer contributes to the pension plan on behalf of each eligible employee to ensure the funds are available for them during retirement. Typically, a defined benefit plan promises a predetermined monthly benefit in retirement. While defined benefit plans were once far more popular, they’re difficult to find in the private sector today. Data from the Bureau of Labor Statistics shows that in 2020, only about 15% of private industry workers have access to a defined benefit plan. That being said, defined benefit plans are still the industry standard for public sector workers. Roughly 94% of state and local government employees had access to a defined benefit plan, according to 2018 data.
How Defined Benefit Plans Work
In the case of many retirement plans, employees are promised a certain contribution from their employers as a percentage of their annual salary. But many employers will only contribute if the employee does so first. Additionally, the amount the employee has available during retirement depends on the investment returns of their retirement account. Defined benefit plans are the opposite. Rather than guaranteeing a certain contribution, these plans guarantee a certain monthly benefit during retirement. Most often, companies use a formula to determine what benefit an employee will receive. For example, a company might promise a certain monthly dollar amount multiplied by the number of years an employer worked with the company. The company contributes to the pension plan on behalf of its eligible employees and then invests those contributions. But the main feature that makes defined benefit plans stand out among other employer-sponsored retirement plans is that the investment returns don’t affect the benefit an employee receives during retirement. In that sense, the employer takes on all the risks. There are two other characteristics of defined benefit plans to know about: vesting and distributions.
Vesting
The federal law that governs defined benefit plans requires there to be a vesting schedule, which outlines how long an employee must work for the company before they start earning retirement benefits. The two vesting schedules that a company may choose from are cliff vesting and graduated vesting. In a cliff vesting schedule, an employee doesn’t have access to the defined benefit plan for a set number of years when they start working. They become fully vested once they reach a certain threshold. In a graduated vesting schedule, the employee becomes partially vested each year until they reach 100% vesting.
Distributions
Like other retirement plans, defined benefit plan participants must reach a certain age before they can take plan distributions without penalty. Companies can allow their employees to receive benefits as early as 55 as long as they have retired by that time. And starting at age 62, companies can start paying pension benefits to participants who haven’t retired. Pension plans often give employees the options of different types of distributions. They can typically choose between a lump-sum distribution when they retire or monthly annuity payments throughout retirement. In the case of the lump-sum payment, employees often roll them over into individual retirement accounts (IRAs), where they can then manage the funds themselves.
Defined Benefit Plan vs. Defined Contribution Plan
A defined benefit plan is a type of employer-sponsored retirement account available to some employees, but these plans have become less common. It’s more likely that employers will offer a defined contribution plan. In fact, 64% of private industry workers had access to a defined contribution plan in 2020. The key difference between a defined benefit plan and a defined contribution plan is what is guaranteed to the worker. With a defined benefit plan, the company promises a certain retirement benefit, which the worker receives regardless of the investment returns. As a result, the investment risk falls on the employer. In the case of a defined contribution plan, however, the employer promises a certain contribution. But the amount that will be available to the employee during retirement depends on the investment returns as well as their own contributions. As a result, the investment risk is on the employee. The most well-known type of defined contribution plan is the 401(k) plan. But no matter what type of retirement plan your employer offers, you still have the opportunity to invest in your own retirement, often with the help of your employer. Vanguard’s 2021 How America Saves survey indicates that 96% of companies that offer a 401(k) plan also offer employer contributions.
