Defined benefit pension plan: Meaning, Criticisms & Real-World Uses

What Is a Defined Benefit Pension Plan?

A defined benefit pension plan is a type of retirement plan, falling under the broader category of retirement planning, in which an employer promises a specified monthly benefit to an employee upon retirement. This benefit is typically calculated using a formula that considers the employee's salary, years of service, and sometimes age. In essence, the employer bears the investment risk and is responsible for ensuring that sufficient funds are available to pay the promised benefits, distinguishing it from plans where the employee takes on this risk. The employer funds the plan, often through a pension fund, and manages the investments to meet future obligations.

History and Origin

The concept of pensions, broadly speaking, has roots in ancient Rome, but private pension plans in the United States began to emerge in the late 19th century. American Express Company established one of the first private pension plans in the U8.S. in 1875¹¹. Other major corporations, including U.S. Steel, Standard Oil, and Goodyear, followed suit around the turn of the 20th century¹⁰. These early defined benefit plans were a tool for companies to attract and retain workers, reduce employee turnover, and provide a means for older, less productive employees to retire⁸, ⁹.

The growth of defined benefit plans accelerated following the Revenue Act of 1913, which granted tax-exempt status to retirement plans, enhancing their economic appeal for employers⁶, ⁷. Further tax benefits in the 1920s and beyond continued to spur their expansion. By the late 1960s, approximately half of the private-sector workforce in the U.S. was covered by some form of pension plan, predominantly defined benefit plans⁴, ⁵. However, concerns over mismanagement and abuse of pension funds led to the landmark Employee Retirement Income Security Act (ERISA) in 1974. ERISA set federal standards for participation, vesting, funding, and fiduciary conduct, and also established the Pension Benefit Guaranty Corporation (PBGC) to insure defined benefit plans², ³. While ERISA aimed to protect workers' benefits, some argue that the legislation also increased the burden on employers, contributing to a shift away from defined benefit plans in the private sector over the following decades¹.

Key Takeaways

A defined benefit pension plan provides a guaranteed retirement income to employees, with the employer bearing the investment risk and funding responsibility.
Benefits are typically calculated based on a formula involving salary, years of service, and sometimes age.
These plans were prevalent in the private sector throughout much of the 20th century, serving as a tool for employee retention.
The Employee Retirement Income Security Act (ERISA) of 1974 established regulations and protections for defined benefit plans, including the creation of the PBGC.
In recent decades, there has been a significant shift in the private sector from defined benefit plans to defined contribution plans.

Formula and Calculation

The formula for a defined benefit pension plan can vary, but a common structure uses a percentage of the employee's final average salary multiplied by their years of service.

A simplified formula might look like this:

\text{Annual Benefit} = \text{Benefit Multiplier} \times \text{Final Average Salary} \times \text{Years of Service}

Where:

Benefit Multiplier: A percentage (e.g., 1% or 2%) set by the plan that determines the annual benefit accrual.
Final Average Salary: The average of the employee's highest earnings over a specified period, often the last 3 or 5 years of employment. This is a crucial input, as a higher average salary generally leads to a larger benefit.
Years of Service: The total number of years an employee has worked for the employer and participated in the plan. Longer employee tenure typically results in a greater benefit.

For example, a plan might offer an annual benefit equal to 1.5% of the final average salary for each year of service. If an employee has a final average salary of $70,000 and 30 years of service, their annual pension benefit would be calculated as:

\text{Annual Benefit} = 0.015 \times \$70,000 \times 30 = \$31,500

This means the employee would receive $31,500 per year in retirement. The employer is responsible for funding the plan to ensure these payments can be made, often requiring actuarial calculations to project future liabilities.

Interpreting the Defined Benefit Pension Plan

A defined benefit pension plan is interpreted as a guarantee of future income, providing a predictable and stable stream of payments during retirement. For employees, this means a significant reduction in retirement risk, as they are not exposed to market fluctuations or the responsibility of managing investment portfolios. The predictability of income allows retirees to plan their post-employment finances with greater certainty.

From an employer's perspective, offering a defined benefit plan can be a powerful tool for attracting and retaining talent, fostering employee loyalty, and managing workforce demographics by encouraging timely retirement. However, the employer assumes the investment risk and the administrative burden of managing the plan and its assets. The interpretation of the plan's health often involves evaluating its funded status—the ratio of assets to liabilities—which can be a complex actuarial exercise requiring expert analysis of actuarial assumptions and market conditions.

Hypothetical Example

Consider Sarah, who works for "Tech Solutions Inc." and is covered by their defined benefit pension plan. The plan's formula states that upon retirement, employees receive an annual pension equal to 2% of their final five-year average salary for each year of service.

Sarah's career at Tech Solutions:

She worked for 25 years.
Her salary for the last five years was:
- Year 1: $80,000
- Year 2: $82,000
- Year 3: $85,000
- Year 4: $88,000
- Year 5: $90,000

First, calculate Sarah's final five-year average salary:

\text{Final Average Salary} = \frac{(\$80,000 + \$82,000 + \$85,000 + \$88,000 + \$90,000)}{5} = \frac{\$425,000}{5} = \$85,000

Next, calculate Sarah's annual pension benefit:

\text{Annual Benefit} = 0.02 \times \$85,000 \times 25 = \$42,500

Upon retirement, Sarah will receive a guaranteed annual pension of $42,500 from Tech Solutions Inc. for the rest of her life. This stable income provides her with financial security and reduces her reliance on personal savings and investment returns.

Practical Applications

Defined benefit pension plans, though less common in the private sector today, still have significant practical applications, particularly within the public sector and for certain unionized workforces.

Public Sector Employment: Many government entities, including federal, state, and municipal governments, continue to offer defined benefit plans to their employees (e.g., teachers, police officers, firefighters). These plans serve as a crucial component of public employee compensation packages, helping to attract and retain skilled professionals in public service.
Unionized Industries: Some union contracts still include defined benefit plans as a key employee benefit. These plans are often collectively bargained and provide a strong incentive for long-term employment within specific industries.
Retirement Security: For employees covered by these plans, the most direct practical application is the provision of guaranteed retirement income. This allows individuals to plan their post-career finances with greater certainty, reducing concerns about market volatility and longevity risk. The employer assumes the responsibility for funding and investment management, providing a significant layer of longevity insurance.
Workforce Management: From an employer's perspective, defined benefit plans can be used strategically for workforce management. They can encourage employees to stay with the company for longer periods to maximize their pension benefits, thereby reducing employee turnover and preserving institutional knowledge. They can also facilitate orderly retirements by offering predictable retirement benefits.
Pension Fund Management: The assets of defined benefit plans are typically managed by professional asset managers within a pension fund. This involves complex investment strategies to ensure the fund can meet its future obligations. The Pension Benefit Guaranty Corporation (PBGC) plays a critical role in insuring these plans in the private sector, stepping in to pay benefits if a plan fails. More information on the PBGC and its role can be found on its official website, PBGC.gov.

Limitations and Criticisms

Despite their benefits, defined benefit pension plans face several limitations and criticisms, primarily from the perspective of the employer and broader economic shifts.

Employer Risk and Cost: A primary criticism is that the employer bears all the investment risk. If the pension fund's investments underperform or if retirees live longer than expected (longevity risk), the employer must contribute more to meet the promised benefits, potentially impacting the company's financial statements and cash flow. This open-ended liability can be a significant financial burden, especially for companies in mature or declining industries.
Funding Challenges: Maintaining adequate funding for defined benefit plans can be challenging, particularly during economic downturns or periods of low interest rates, which increase the present value of future liabilities. Underfunded pension plans can pose a risk to both the employer's stability and the security of employee benefits. The Government Accountability Office (GAO) often publishes reports and information related to the financial health of pension plans, highlighting these funding challenges. Relevant reports can be found on the GAO website.
Complexity and Administration: Defined benefit plans are complex to administer, requiring actuarial valuations, compliance with extensive regulations (like ERISA), and ongoing investment management. This administrative burden and associated costs can be prohibitive for many businesses, especially smaller ones.
Lack of Portability: Historically, defined benefit plans often had strict vesting schedules and limited portability, meaning employees who changed jobs frequently might lose a significant portion of their accrued benefits. While ERISA improved vesting requirements, the benefits are generally tied to a single employer, making them less flexible for a mobile workforce.
Transparency Issues: The complexity of defined benefit plans can sometimes lead to a lack of transparency for employees regarding how their benefits are calculated and the financial health of the plan. This contrasts with the clear account balances seen in defined contribution plans.
Impact of Economic Cycles: Economic downturns can severely impact pension fund assets, exacerbating underfunding issues and leading to increased contribution requirements for employers. Conversely, strong economic growth may not always fully offset prior shortfalls, leaving long-term funding gaps.

These limitations have contributed to the significant decline in defined benefit plans in the private sector, as employers have increasingly favored defined contribution plans that shift the investment risk and administrative burden to employees.

Defined Benefit Pension Plan vs. Defined Contribution Plan

A defined benefit pension plan and a defined contribution plan are two primary types of employer-sponsored retirement plans, but they differ fundamentally in terms of who bears the investment risk, how benefits are determined, and the nature of the employer's commitment.

Feature	Defined Benefit Pension Plan	Defined Contribution Plan
Benefit Payout	Guaranteed, predetermined benefit at retirement (e.g., a fixed monthly income for life).	Retirement income depends on contributions and investment performance of the individual account.
Investment Risk	Borne by the employer. The employer is responsible for ensuring sufficient funds exist to pay promised benefits.	Borne by the employee. The employee chooses investments and assumes market risk.
Contributions	Employer makes contributions based on actuarial calculations to meet future benefit obligations. Employees typically do not contribute.	Both employer and employee can make contributions to an individual account (e.g., 401(k), 403(b)).
Benefit Calculation	Based on a formula (e.g., salary, years of service, age).	Based on total contributions to the account plus investment gains or losses.
Portability	Generally less portable; benefits often tied to continued employment with the same employer.	Highly portable; employees can typically roll over their accounts when changing jobs.
Administration	Complex; requires actuarial analysis, professional management of a pension fund, and compliance with strict regulations.	Simpler; involves managing individual employee accounts.
Insurance	Insured by the Pension Benefit Guaranty Corporation (PBGC) in the private sector.	Not insured by the PBGC; individual account balances are subject to market fluctuations.

The key point of confusion often lies in the "guarantee." In a defined benefit plan, the benefit is guaranteed by the employer, whereas in a defined contribution plan, only the contribution is defined, with the final benefit fluctuating based on investment performance. This distinction significantly impacts the risk allocation between employer and employee.

FAQs

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

"Defined benefit" means that the retirement benefit an employee will receive is predetermined by a formula, typically based on their salary history, years of service, and age. The employer guarantees this specific benefit amount, regardless of how the plan's investments perform.

How is a defined benefit plan funded?

A defined benefit plan is funded by the employer, who makes contributions to a pension fund. These contributions are calculated by actuaries to ensure enough money is available to pay out the promised benefits to all eligible employees in the future. Employees generally do not contribute to these plans.

Are defined benefit plans still common today?

Defined benefit plans have become less common in the private sector over the past few decades, largely replaced by defined contribution plans like 401(k)s due to the financial risks and administrative complexities for employers. However, they remain prevalent in the public sector, covering many government employees at federal, state, and local levels.

What happens if an employer's defined benefit plan is underfunded?

If a private-sector employer's defined benefit plan is underfunded, it means the plan does not have enough assets to cover all its promised future benefits. The employer is typically required to make additional contributions to address the shortfall. In severe cases of underfunding or plan termination, the Pension Benefit Guaranty Corporation (PBGC) may step in to provide guaranteed benefits, though there are limits to what the PBGC covers.

Do employees have control over investments in a defined benefit plan?

No, employees typically do not have control over the investments in a defined benefit plan. The employer, or a designated pension fund manager, is responsible for investing the plan's assets to meet the future benefit obligations. This shifts the investment responsibility and risk away from the employee.