A defined benefit plan, more commonly known as a pension plan, offers guaranteed retirement benefits for employees. Defined benefit plans are primarily funded by employers, with retirement payouts based on a formula that considers an employee’s salary, age, and tenure with the company.
In an age of defined contribution plans like 401(k)s, defined benefit plans are becoming less and less common, despite the retirement certainty and security pension plans offer.
How Does a Defined Benefit Plan Work?
Defined benefit plans offered guaranteed salary-like payments and were historically offered to entice workers to stay with one company for years or even decades. Thanks to the rise of lower-cost defined contribution plans, however, defined benefit plans are much less prevalent now. In 1980, 83% of private sector workers had a defined benefit plan as an option. In 2018, only 17% of private sector workers had the option.
A defined benefit plan is a qualified employer-sponsored retirement plan. This means they can receive certain tax benefits under the law, like tax-deferred investment growth or tax deductions for contributions. You’re probably more familiar with qualified employer-sponsored retirement plans like a 401(k). Unlike 401(k)s, defined benefit plans are usually funded entirely by employer contributions, although in rare cases, employees may be required to make some contributions.
The retirement benefits provided by a defined benefit plan are typically based on a formula that considers factors like your time with the company, your salary, and your age. For instance, a company might offer a plan that pays 1.5% of your average salary for the last five years of your employment for every year you were at a company. If you worked for that company for 20 years, you might see a payment of 30% of your average salary.
It’s important to note that no single method defined benefit plans use to calculate employee benefits. A formula might be based on an employee’s average salary for their last three years with a company—or their last five years. It might also be found on the employee’s average wage for their whole career with a company—or there might be a flat dollar benefit, such as $800 for each year an employee has been with the firm. If you are eligible for a pension plan, check how your benefits will be calculated.
Employers generally get tax breaks for contributing to these plans. Still, they’re also on the hook for providing guaranteed payments to beneficiaries, no matter how the underlying investments in a plan might perform. This is one of the most significant distinguishing factors between pension plans and 401(k)s, whose future payments rely entirely on unassured investment performance. In addition, the benefits in most defined benefit plans are protected, within certain limitations, by federal insurance provided through the Pension Benefit Guaranty Corporation (PBGC).
Defined Benefit Plan Payment Options
When it comes time to collect your retirement, you usually receive payment in the form of a lump sum or an annuity that provides regular payments for the rest of your life. Deciding between the two can be a difficult decision, especially since there are different ways an annuity could be structured:
• Single life payment. You receive a monthly fee for the rest of your life; if you die, your beneficiaries receive no further payments.
• Single life with term particular. You receive a monthly payment, and if you die before the specified term is over, your beneficiaries receive payments for several years.
• 50% joint and survivor. When you die, your surviving spouse will get monthly payments for the rest of their life equal to 50% of your original annuity.
• 100% joint and survivor. When you die, your surviving spouse will get monthly payments for the rest of their life, equaling 100% of your original annuity.
Adding more stipulations to your annuity means you’ll get lower monthly payments. But if you’re in good health and expect to live a long life, you’ll usually get the most benefit from choosing annuity payments.
A lump sum may be best if you’re in poor health and expect a short retirement. You may also choose to take a lump sum payment and invest it or use it to buy an annuity of your own.
Defined Benefit Plan Contribution Limits
Although employees generally have little control over their benefits, there are still annual limits for defined benefit plans. In 2022, the annual benefit for an employee can’t exceed the lesser of 100% of their average compensation for their highest earning three consecutive calendar years or $245,000. This is up from $230,000 in 2021 and 2020.
Types of Defined Benefit Plans
Two main types of defined benefit plans are pensions and cash balances.
Pensions
People typically understand a defined benefit plan as a pension: A guaranteed monthly benefit starting at retirement, based on a formula that determines how long a worker remained with a company and how much they earned.
Employees usually must remain with a company for a certain period to earn pension benefits. After raising the required tenure, an employee is considered “vested.” Pension plans may have different vesting requirements. For instance, an employee might be 20% vested after one year with a company, granting them retirement payments equal to 20% of a full pension.
Vesting schedules are also a standard part of defined contribution plans. About half of 401(k)s have a vesting schedule for employer contributions.
Cash Balance Plans
Cash balance plans are defined benefit plans that grant employees a set account balance at retirement or when they leave the company instead of a fixed monthly benefit. For that reason, many think of them as a hybrid between traditional pensions and 401(k)s.
While employers still take on all the investment risk associated with managing retirement funds, they do not guarantee indefinite benefit payments. Instead, you are guaranteed up to a certain cash balance.
Cash balance plans generally calculate benefits based on your entire working years with a company, not just your last or highest earning period, meaning some people end up with fewer benefits if their companies switch to a cash balance plan from a pension plan.
Employers typically calculate the cash balance based on pay credits and interest credits. An employee’s account is commonly credited each year with a pay credit (such as 3% of compensation from their employer). They’ll also receive an interest credit for the account (usually a fixed or variable rate linked to a benchmark such as the 30-year Treasury bond).
Each year, participants have an annual account balance that becomes theirs upon vesting and that they receive when they leave the company. They will usually have the choice to accept their balance in the form of an annuity that makes regular payments over time or to take the benefit as a lump sum, which they could roll over to an individual retirement account (IRA) or another company’s plan.
Defined Benefit Plan vs. Defined Contribution Plan
Think of defined contribution plans as the new kid on the block and defined benefit plans as the old pro. A defined benefit plan primarily requires employers to make nearly all contributions. In contrast, a defined benefit plan expects employees to make the most of the gifts—even though many employers may choose to provide some matching grants.
While defined benefit plans generally guarantee either a monthly payment or a set lump-sum payout, depending on your salary or how long you remain with a company, limited contribution plan payouts aren’t guaranteed—they rely on employee contributions and the performance of the underlying investments. Defined benefit plans offer greater assurance of some returns, although you could achieve higher earnings by managing your retirement funds.
Defined contribution plans are much more common than defined benefit plans, with 43% of the private sector, state, and local government workers participating in one. While they are no longer common among private companies, defined benefit plans remain prevalent in state and local governments, with 76% of public employees participating in a pension plan.
Defined Benefit Plan Advantages
• Retirement paycheck security: Employee benefits are guaranteed in a defined benefit plan, offering employees the deposit of a regular paycheck in retirement.
• Payments are not affected by market fluctuations: No matter what the underlying investments do, the employee retirement benefit stays the same.
• Potential for spousal support: A spouse may be able to continue receiving guaranteed payments after the employee’s death.
• Employer tax benefits: Employers generally get a tax deduction for contributions to defined benefit plans.
• Improved retention: Defined benefit plans can keep employees with a company for an extended period as they wait to vest and earn the most retirement benefits.
Defined Benefit Plan Disadvantages
• No investment choice: Employees have no say in what their money is invested in.
• It takes time to vest: If a company requires that an employee stays for five years to vest and leaves after three, all the money they earned remains with the company.
• Lack of portability: Moving money from plan to plan may be challenging as an employee changes jobs, although this may be easier with cash balance plans. This doesn’t mean you won’t still receive your total collective benefits in retirement. You’ll just have to keep up with multiple sources of income.
• No chance to increase your benefit: The benefit formula is the benefit formula, so an employee can’t improve their retirement paycheck. Employees can contribute more money or invest more aggressively to improve their returns with defined contribution plans. Those with defined benefit plans can also increase their retirement savings using IRAs, discussed more below.
• Expensive to maintain: Because they offer guaranteed payments regardless of market conditions, defined benefit plans are more expensive for employers to maintain than defined contribution plans.
Once you’ve figured out how much you need to support your lifestyle, subtract your estimated payments from your defined benefit plans and Social Security. Then set savings goals to help you make up the difference.
Even if you have a pension, you can save in tax-deferred accounts like traditional IRAs or after-tax accounts like Roth IRAs. In 2022, you can save up to $6,000 in an IRA or up to $7,000 if you’re 50 or older.
And if you don’t have a defined contribution plan but desire some of the security they provide, you can use your defined contribution plan—a 401(k) or 403(b), for instance—to purchase an annuity that provides a steady stream of income payments in retirement.
Annuities, however, aren’t for everyone and often charge high fees or require confusing and complicated contracts. Be sure to talk with a financial advisor to determine how annuities might fit into your retirement plan.
