A defined-benefit plan is an employer-promised specified/pre-determined pension payment plan that can be received in a lump sum, periodically, or both. The payment plan is “defined” in advance and based on the employee’s earnings history, tenure, and age – not solely on the individual investment returns.
For most defined-benefit plans, the employer funds the program; however, in some cases, employees will also make contributions. The employer is responsible for the management and risk assessment of the investment and will most often use an outside firm to control the portfolio. The defined-benefit plan is also known as a pension plan or a qualified benefit plan.
Distribution of a Defined-Benefit Plan
Defined-benefit plans can be distributed in many ways depending on the preference of the company. A joint and survivor annuity will administer the benefits through a life annuity to the employee. Once the primary employee passes away, the spouse will continue to receive benefits of at least 50% until their passing.
Employees would receive their benefit payments periodically (monthly, quarterly, etc.), in a lump sum, or a combination, for the remainder of their lives. A straight-life annuity will be receiving a monthly (or periodic) sum of their benefit until they die. Some plans will consist of only one lump sum after retirement, and no further payments will be made after the initial payment. The benefits received by retirees will be taxable.
The same benefits will give companies a tax break if their contribution is equal to the established defined-benefit plan. Contributions that fall short or contributions above the defined plan will be subject to federal taxes. Often, to receive full benefits, the employee will have had to be with the company for a certain number of years known as the “vesting period.”
1. Career Average Earnings Benefit/Year
The benefit is found by multiplying the defined % (less than 2%) of the average monthly earnings over their career by the number of years worked for the company.
(Defined %) * (Average Monthly Earnings over Career) * (Years of Service)
2. Final Earnings Benefit/Year
The benefit is found by multiplying the defined % (less than 2%) of the average monthly earnings over the last 5 years by the number of years worked for the company.
(Defined %) * (Average Monthly Earnings over Last 5 Years) * (Years of Service)
3. Flat Benefit/Year
The benefit is found by multiplying a defined dollar amount by the number of years of service.
Defined Dollar Amount * (Years of Service)
The calculation methods above are only a few of many ways that a defined-benefit plan can be calculated. It comes down to the preference of each business, and how they determine which plan to go for and the opportunity cost of each.
Defined-Benefit Plans vs. Defined-Contribution Plans
Similar to a defined-benefit plan, defined-contribution plans are another type of employer-sponsored retirement savings plan. The core difference between the two methods is who the investment risk falls on.
The defined-contribution plan is funded by employees, which results in them bearing the investment risk. Defined-benefit programs don’t rely on the investment returns, and the employees will know the amount of the benefit they are expected to receive post-retirement.
Often, employers now prefer defined-contribution plans over defined-benefit plans because it costs the company less money, and the investment risk falls on the employee rather than the organization.
Pros and Cons of a Defined-Benefit Plan for the Employee
1. Fixed payout
A defined-benefit plan gives the employee a fixed payout that is not based on the investment results. Instead, it is determined using the previously agreed-upon formula that considers the aforementioned factors, which can include earnings, length of employment, and age.
2. Less risky for the employee
The investment risk then falls onto the employer and not the employee. The employee is also not required to contribute to the plan, meaning there is no cost to them. From the negative side, employees do not have any input on how the money is invested, leaving the potential for poor management, and the results are sometimes not adjusted for inflation.
3. Encourages employee retention
Finally, the employee is expected to take a vested interest in the company and stay with them for an extended period to receive their full benefits. If they were to leave early, they would only receive a portion or none of their benefits.
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