What is a defined benefit plan?
A defined benefit plan is an employer-sponsored pension plan in which employee benefits are calculated using a formula that takes into account several factors, such as length of employment and history. salaries.The firm is responsible for the investment and risk management of the plan and will typically hire an outside investment manager to do so. Typically, an employee cannot simply withdraw funds like with a 401 (k) plan. Instead, they become eligible to receive their benefit as a life annuity or, in some cases, as a lump sum at an age defined by the rules of the plan.
Understanding the defined benefit plan
Also known as a pension plan or qualified benefit plan, this type of plan is called âdefined benefitâ because employees and employers know in advance the formula for calculating pension benefits and use it to define and set benefits. paid. This fund is different from other retirement funds, such as retirement savings accounts, where payment amounts depend on investment returns. Bad returns on investment or erroneous assumptions and calculations can lead to a funding gap, with employers being legally required to make up the difference with a cash contribution.
Key points to remember
- A defined benefit plan is an employer-sponsored program that pays benefits based on factors such as length of employment and salary history.
- Pensions are defined benefit plans.
- Unlike defined contribution plans, the employer, not the employee, is responsible for all planning and investment risks of a defined benefit plan.
- Benefits can be distributed as fixed monthly payments like an annuity or as a single payment.
- The surviving spouse is often entitled to benefits in the event of the employee’s death.
Since the employer is responsible for making the investment decisions and managing the plan’s investments, the employer assumes all investment and planning risks.
Examples of defined benefit plan payments
A defined benefit plan guarantees a specific benefit or payment upon retirement. The employer can opt for a fixed benefit or one calculated according to a formula taking into account years of service, age and average salary. The employer generally funds the plan by paying a regular amount, usually a percentage of the employee’s salary, into a tax-deferred account. However, depending on the plan, employees can also contribute. The employer’s contribution is, in effect, deferred remuneration.
At retirement, the plan can make monthly payments over the life of the employee or as a lump sum payment. For example, a plan for a retiree with 30 years of service at retirement may show the benefit as an exact amount, such as $ 150 per month per year of employee service. This plan would pay the employee $ 4,500 per month upon retirement. If the employee dies, some plans distribute the remaining benefits to the employee’s beneficiaries.
Annuity vs lump sum payments
Payment options typically include a single life annuity, which provides a fixed monthly benefit until death; an eligible joint and survivor annuity, which provides a fixed monthly benefit until death and allows the surviving spouse to continue to receive benefits thereafter;or a lump sum payment, which pays the full value of the plan in one lump sum.
It is important to choose the right payment option because it can affect the amount of benefits that the employee receives. It is best to discuss benefit options with a financial advisor.
Working an extra year increases the employee’s benefits because it increases the years of service used in the benefit formula. This extra year can also increase the final salary that the employer uses to calculate the benefit. In addition, there may be a stipulation that working after the plan’s normal retirement age automatically increases an employee’s benefits.