Defined benefit pensions

What Is Defined Benefit Pensions?

A defined benefit pension is a type of retirement plan in which an employer promises a specific, predetermined monthly benefit to an employee upon retirement, typically for the remainder of their life. This certainty in payout distinguishes defined benefit pensions within the broader category of retirement planning. Unlike other plans where retirement income depends on investment performance, the employer bears the investment risk and is responsible for adequately funding the plan to meet future obligations. The amount an employee receives is usually calculated using a benefit formula that factors in their salary history, years of service, and sometimes age.

History and Origin

The concept of providing for retired workers has roots in military pensions from the colonial era, but formal, employer-provided pensions for civilians in the United States began to emerge in the late 19th century. The American Express Company established what is often cited as one of the first private-sector pension plans in 1875, followed by railroads and other large corporations. These early pension plans were often designed to incentivize long-term employment and reduce employee turnover. The economic boom of the mid-220th century further facilitated the expansion of these plans, with defined benefit structures becoming a cornerstone of American retirement security by the late 1960s, covering roughly half of the private-sector workforce.⁵ The passage of the Employee Retirement Income Security Act (ERISA) in 1974 brought significant regulation to private pension plans, establishing standards for funding, vesting, and fiduciary responsibility.

Key Takeaways

• Defined benefit pensions guarantee a specific, predictable income stream throughout retirement, regardless of market performance.
• The employer is responsible for funding the plan and bears the investment and longevity risks.
• Benefits are typically calculated based on an employee's salary, years of service, and age.
• The Pension Benefit Guaranty Corporation (PBGC) insures many private-sector defined benefit plans.
• These plans generally require employees to meet a vesting schedule to receive full benefits.

Formula and Calculation

The formula for a defined benefit pension varies by plan but typically involves a percentage of the employee's final average salary multiplied by their years of service. A common simplified formula is:

Where:

• Benefit Multiplier: A percentage (e.g., 1.5% or 2%) set by the plan for each year of service.
• Final Average Salary: The average of the employee's highest salary over a specified period, often the last 3 or 5 years of employment.
• Years of Service: The total number of credited years an employee has worked for the employer.

An actuary uses principles of actuarial science to determine the present value of these future obligations and calculate the employer's required contributions to ensure the plan's solvency. The plan's financial health is often measured by its funding ratio.

Interpreting the Defined Benefit Pensions

Interpreting a defined benefit pension primarily involves understanding the guaranteed income it will provide in retirement. Unlike a defined contribution plan, where the account balance fluctuates with market conditions, a defined benefit pension promises a fixed monthly payment at a specified retirement age. This certainty offers significant security for retirees, allowing for more predictable financial planning. The key aspects to interpret are the amount of the monthly benefit, the earliest age at which benefits can be received, and any survivor benefits offered to a spouse or beneficiary. Factors like cost-of-living adjustments (COLAs) are also important, as they determine if the benefit will keep pace with inflation over time.

Hypothetical Example

Consider an employee, Sarah, who works for a company offering a defined benefit pension plan. The plan's formula states that her annual retirement benefit will be 1.5% of her final average salary for each year of service. Sarah's final average salary over her last three years of employment is $80,000, and she has completed 30 years of service when she retires.

Using the formula:

So, Sarah can expect to receive an annual benefit of $36,000 (or $3,000 per month) for the rest of her life, starting at her designated retirement age. This amount is guaranteed by her employer, and the employer is responsible for investing the plan's assets to ensure these payments can be made. If Sarah were to opt for a reduced early retirement annuity or a spousal benefit, the monthly payout would be adjusted accordingly.

Practical Applications

Defined benefit pensions are primarily used by employers, particularly in the public sector (government agencies) and some long-established private companies, as a means of providing guaranteed retirement income to their employees. These plans serve as a powerful tool for employee retention and recruitment due to the perceived security they offer.

For employees, a defined benefit pension simplifies retirement saving, as the employer manages the investments and assumes the associated risks. The predictable income stream helps retirees budget and plan without worrying about market volatility impacting their retirement funds. The Internal Revenue Service (IRS) sets rules and limits for these plans, ensuring they adhere to specific regulations for tax-advantaged status.⁴ Furthermore, the Pension Benefit Guaranty Corporation (PBGC) provides insurance protection for eligible private-sector defined benefit plans, safeguarding a portion of promised benefits even if the employer's plan becomes underfunded or terminates.³

Limitations and Criticisms

Despite the security they offer to employees, defined benefit pensions face several limitations and criticisms, primarily concerning their cost and the financial burden they place on employers. The primary risk for employers is the longevity risk, as retirees are living longer than anticipated, requiring benefit payments for extended periods. Employers also bear significant investment risk; if the plan's assets do not perform as expected, the employer must contribute more to meet the promised benefits. This can lead to substantial unfunded liabilities, especially during economic downturns or periods of low interest rates.

The administrative complexity and regulatory burden associated with defined benefit pensions are also considerable. Employers must adhere to strict IRS and ERISA regulations, requiring regular actuarial valuations and complex reporting. For employees, a key criticism can be the lack of portability; benefits are often tied to staying with one employer for a significant period. If an employee leaves before vesting, they may forfeit all or a portion of their accrued benefits. Furthermore, some plans may not offer inflation protection, meaning the purchasing power of the fixed benefit can erode over time. Recent studies have highlighted the challenges states face when attempting to shift away from defined benefit plans, including increased costs and negative cash flow.²

Defined Benefit Pensions vs. Defined Contribution Plans

The fundamental difference between defined benefit pensions and defined contribution plans lies in who bears the investment risk and the nature of the retirement benefit.

In a defined benefit plan, the employee knows what they will receive in retirement, and the employer is responsible for ensuring those funds are available. Conversely, with defined contribution plans, the employee and/or employer contribute a specified amount (the "defined contribution"), but the final retirement benefit depends entirely on the total contributions made and the investment returns of the employee's individual account within tax-advantaged accounts. This shifts the investment risk, and the responsibility for managing asset allocation, from the employer to the employee.

FAQs

What happens to a defined benefit pension if the company goes out of business?

If a private-sector company with a defined benefit pension plan goes out of business or the plan is terminated, the Pension Benefit Guaranty Corporation (PBGC) steps in to protect a portion of the promised benefits. The PBGC, a U.S. government agency, acts as an insurer for these plans, paying benefits up to certain legal limits.¹

Are defined benefit pensions still common?

Defined benefit pensions have become less common in the private sector in recent decades due to increased costs, regulatory burdens, and longevity risk for employers. However, they remain prevalent in the public sector, such as for government employees, teachers, and firefighters.

Can I contribute to a defined benefit pension?

In most traditional defined benefit plans, only the employer makes contributions to the plan. Some plans, particularly older or public-sector plans, may require or allow employee contributions, but these are less common in modern private-sector defined benefit arrangements.

Is a defined benefit pension a good retirement plan?

For employees, defined benefit pensions are generally considered highly valuable because they provide a guaranteed, predictable income stream for life, removing the burden of investment management and market risk from the individual. This certainty can greatly simplify retirement planning. However, they may offer less flexibility or portability compared to other types of plans.

What is vesting in a defined benefit pension?

Vesting refers to the point at which an employee gains non-forfeitable rights to their pension benefits. Even if they leave the company before retirement, once vested, they are entitled to receive their accrued benefit at the plan's specified retirement age. Vesting schedules vary but are regulated by ERISA.