Simply put, a defined benefit plan is a pension plan that uses a formula to promise a predetermined monthly benefit to an employee at their retirement. However, the specifics that go into a defined benefit plan are less simple, and it is important for all involved to understand the ramifications of the plan before it is entered into.
The Formula for Defined Benefit Plans
Most plans use a formula that includes the employee’s earnings, years of employment and age at retirement. As of 2014, the IRS caps this type of retirement benefit at $210,000.
The final salary plan takes into consideration the employee’s number of years worked and then multiplies that by the current salary at the time of retirement, and then finally, multiplies it by an accrual rate. The accrued amount is then available to the employee as either monthly payments or a lump sum.
Types of Defined Benefit Plans
Defined benefit plans can be either funded or unfunded. An unfunded plan means that the company does not set aside any assets to ensure benefits can be paid when the plan goes into effect. This is known as a Pay-as-you-go plan. In the United States, these plans are only allowed in the public sector.
The second type of plan is a funded plan. In this case, the employer, and sometimes the employee make contributions to the plan, so future benefit obligations can be met. These contributions are then examined by an actuary at certain intervals to ensure that the contribution level, as well as the investment of the contributions, will equal or surpass the benefit obligations.
Disadvantage and Advantages of Defined Benefit Plans
The disadvantage of the defined benefit plan is that it is less portable than other pension plans. The advantage, however, is that most plans will pay the benefit to the employee as an annuity, so there is less chance that the employee will out live their retirement benefits.
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