Defined benefit

What Is Defined Benefit?

A defined benefit plan is a type of employer-sponsored pension plan that promises a specific, predetermined retirement benefit to employees. Unlike other retirement savings vehicles, the employer bears the investment risk and is responsible for funding the plan to ensure that the promised benefits can be paid. This form of retirement arrangement falls under the broader category of retirement planning and employee benefits. Participants in a defined benefit plan typically know the amount of income they will receive in retirement, often based on a formula that considers factors such as their salary history and years of service with the company.

History and Origin

The concept of a defined benefit plan has roots in the late 19th century in the United States. Early examples include the American Express Company, which established one of the first private pension plans in 1875, and the Baltimore and Ohio Railroad in 1880. These initial plans often paid workers a specific monthly benefit at retirement, funded entirely by the employers.¹⁴,¹³

However, until the mid-20th century, these private pensions largely lacked protection, leaving employees vulnerable if their employer faced financial difficulties or terminated a plan. A significant catalyst for reform was the 1963 closure of the Studebaker automobile plant in South Bend, Indiana, where over 8,500 workers lost some or all of their promised pension benefits.¹²,¹¹ This event spurred calls for legislative action. In response, Congress passed the Employee Retirement Income Security Act of 1974 (ERISA), which President Gerald R. Ford signed into law on September 2, 1974.¹⁰,⁹ ERISA established minimum standards for most private-sector retirement plans, including defined benefit plans, and created the Pension Benefit Guaranty Corporation (PBGC) to insure these benefits.⁸,⁷

Key Takeaways

• A defined benefit plan guarantees a specific retirement income, with the employer responsible for funding and investment risk.
• Benefits are typically based on a formula involving salary, years of service, and age.
• The employer, not the employee, is responsible for managing the plan's assets and ensuring sufficient funding.
• Defined benefit plans are insured by the Pension Benefit Guaranty Corporation (PBGC) in the private sector, providing a safety net for participants.
• While historically common, defined benefit plans have become less prevalent in the private sector compared to defined contribution plans.

Formula and Calculation

Unlike a defined contribution plan where an individual's retirement balance is based on contributions and investment performance, a defined benefit plan provides a pre-determined benefit. The formula for this benefit is established by the employer and typically involves an employee's final average salary, years of service, and a fixed percentage or factor.

For example, a common formula might be:

• Final Average Salary: This is often the average of the employee's highest few years of compensation.
• Benefit Multiplier: A percentage set by the plan, e.g., 1.5% or 2%.
• Years of Service: The total number of years the employee worked for the company while participating in the plan.

The employer uses actuarial science to calculate the required contributions to the plan to meet these future obligations. This involves complex projections of employee demographics, investment returns, and life expectancies. The employee does not directly contribute a fixed amount or manage investments; instead, they receive a promised benefit.

Interpreting the Defined Benefit

Interpreting a defined benefit plan means understanding the specifics of the promised income stream. For an employee, this certainty of a future income is a significant advantage in retirement income planning. The plan's provisions will detail when an employee is eligible to receive benefits (e.g., normal retirement age), how benefits are calculated, and what options exist for benefit distribution (e.g., single life annuity or joint and survivor annuity).

Key aspects to interpret include the vesting schedule, which dictates when an employee gains a non-forfeitable right to their benefits.⁶ Understanding the benefit formula allows employees to project their estimated retirement income, which can be a cornerstone of their overall financial strategy.

Hypothetical Example

Consider Sarah, an employee at "Tech Solutions Inc." The company offers a defined benefit plan with a formula of 1.5% multiplied by her average final five years' salary, multiplied by her years of service.

Sarah's details:

• Years of Service: 30 years
• Average Final Five Years' Salary: $100,000

Using the formula:
Annual Benefit = $100,000 (Final Average Salary) × 0.015 (Benefit Multiplier) × 30 (Years of Service)
Annual Benefit = $45,000

When Sarah retires, she is promised a payment of $45,000 per year for the rest of her life, typically paid in monthly installments. Tech Solutions Inc. is responsible for ensuring the plan has enough assets to pay this benefit, regardless of market fluctuations. This predictability contrasts sharply with other retirement accounts, where the final benefit depends on the accumulated balance.

Practical Applications

Defined benefit plans are significant components of qualified retirement plans and play a crucial role in providing long-term financial security. They are particularly prevalent in the public sector, such as for government employees, teachers, and police officers, though they have become less common in the private sector.

For employers, offering a defined benefit plan can be a powerful tool for employee retention, as the promise of a guaranteed retirement income incentivizes long-term employment. These plans also fall under stringent regulatory oversight, primarily through ERISA, which sets standards for reporting, disclosure, and fiduciary duty. The Pension Benefit Guaranty Corporation (PBGC) insures many private-sector defined benefit plans, providing a safety net if a plan becomes unable to pay its promised benefits., T⁵his insurance helps protect millions of American workers and retirees.

Limitations and Criticisms

Despite the security they offer to employees, defined benefit plans face several criticisms and limitations, particularly from an employer's perspective. The primary challenge is the employer's responsibility for funding and managing the associated liability. Companies must make ongoing contributions to cover future benefit payments, which can become very costly and unpredictable, especially with fluctuations in investment returns and increases in life expectancy. This financial burden can be a drag on corporate earnings and competitiveness.,
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The complexity of administering these plans, coupled with the stringent regulations imposed by the Internal Revenue Code and ERISA, adds to the administrative overhead., ³M²any private-sector employers have shifted away from defined benefit plans due to these high costs, volatility, and administrative burdens, preferring defined contribution plans like the 401(k))., T¹his shift places more of the investment risk and responsibility for retirement savings onto individual employees.

Defined Benefit vs. Defined Contribution

The fundamental difference between a defined benefit plan and a defined contribution plan lies in who bears the risk and what is defined.

A defined contribution plan, such as a 401(k), specifies the contributions made by the employer, the employee, or both, into an individual account. The ultimate retirement benefit depends on the amount contributed, the investment performance of the account, and any fees incurred. The employee controls the investment choices and bears the market risk. In contrast, a defined benefit plan provides a guaranteed payment, shifting the investment and longevity risk to the employer.

FAQs

What does "vesting" mean in a defined benefit plan?

Vesting refers to the point at which an employee gains a non-forfeitable right to their retirement benefits. Even if they leave the company before retirement, once they are vested, they are entitled to receive their accrued defined benefit when they reach the plan's specified retirement age. The Employee Retirement Income Security Act (ERISA) sets minimum vesting standards for qualified plans.

Are defined benefit plans still common?

In the private sector in the U.S., defined benefit plans have become far less common than they once were. Many companies have frozen or terminated these plans in favor of defined contribution plans like the 401(k)), primarily due to the significant financial risk and administrative burden on employers. However, they remain prevalent in the public sector for government employees.

How is a defined benefit plan different from Social Security?

While both provide a form of guaranteed income in retirement, Social Security is a government-run social insurance program funded by payroll taxes, designed to provide a basic safety net for most American workers. A defined benefit plan is typically an employer-sponsored private or public pension plan specific to that employer's workers, with benefits determined by the plan's specific formula and funded by the employer (and sometimes employee contributions).

What happens if an employer goes out of business and can't pay its defined benefit plan?

If a private-sector employer can no longer fulfill its obligations under a defined benefit plan, the Pension Benefit Guaranty Corporation (PBGC), a U.S. government agency, typically steps in. The PBGC provides a safety net, paying guaranteed benefits up to a legally defined maximum limit, ensuring that retirees still receive a portion of their promised pension, even if the company fails.