Defined benefit pension plan

A defined benefit pension plan is a type of retirement plan in which an employer allocates specific amounts of money for participating, vested employees in a tax deferred account. The plan is referred to as defined because the formula for calculating the amount contributed by an employer is known in advance. In the United States of America, the monthly payment a retiree receives from a defined benefit plan (commonly referred to as a DB plan) is not dependent on the success or failure of the portfolio in which the employer's contributions are invested. This characteristic places the entire liability of market fluctuations and the particular portfolio's performance on the employer (or the plan sponsor).

The monthly payment that a participating employee receives is called their benefit. It is traditionally calculated based on length of employment and terminal wages. In some instances, the management level of a participant will also factor into the calculation. Because of the plan's tax-deferred status, there are restrictions on how early benefits can be received. The academic study of retirement is generally in the field of financial economics, but it can also be examined in sociology, political economics, and the study of aging.

Eligibility

To be eligible to receive benefits from a DB retirement plan in the United States, an employee must first work for an employer who is offering the plan. Since the introduction of defined contribution plans (or DC plans) in the 1980s, the number of defined benefit plans has shrunk considerably due to the decreased risk put on the employer by DC plans. Only about 10% of employees in the United States private sector have defined benefit plans, although 90% of state and local governments still offer the plans.

Once an employee is hired, they must meet participation requirements in order to join the plan. Requirements are often either one year of employment with the plan sponsor or 1000 hours of service (about half a year of full-time employment on a 40-hour work week).

Calculation of defined benefit pension plans

Vesting

See also Vesting

After joining, the employee (now a participant) must become vested in the plan or else they will not receive benefits upon retirement. A vesting percentage determines how much of the calculated benefit a participant will receive once they retire. Employers in the United States are permitted by law to require a participant to work at least 5 years before becoming 100% vested. However in a graduated vesting schedule, the employer may require 7 years for 100% vested, but they must permit lower percentages of vesting for lesser years of service (such as 60% vested after 4 years of service). Once vested, a participant can terminate their employment at any time and still receive benefits at retirement.

Calculation

The plan sponsor, while working with an outside company that is administrating the plan, can choose to calculate participants' benefits in several ways. In every type of plan in the United States, the final calculation is multiplied by the percent that the participant is vested. For example, if a participant did not meet the vesting requirements of their employer, then the final calculation is multiplied by 0%, resulting in no benefit. If a participant's vesting percentage is 60%, they would receive 60% of the calculated amount of benefit.

Unit credit formula

Benefits at retirement are determined by the years of service to the employer, either as a fixed percentage of compensation per year or as a flat-dollar amount per year.

The former type (sometimes called final pay formula) is the most prevalent formula used and is typically based off the average of a participant's highest earnings for 5 consecutive years in the last 10 years of service. This average is then multiplied by each year of service worked and the total amount is the participant's account balance.

The second type is very rare and it adds a specified dollar amount to the account balance for every year of service.

Fixed benefit formula

The monthly benefit is determined by a fixed percentage of the participant's compensation. The compensation is calculated as an average of a participant's earnings over all years worked at the company. Fixed benefit formula is much less common than the unit credit formula.

Flat benefit formula

Monthly benefits are a flat-dollar amount for every participant regardless of service or compensation.

Management of defined benefit plans

Investment strategies

See also Investment

United States federal retirement laws

See also United States federal retirement laws

A participant must begin receiving payments from their DB plan by April 1 following the year in which they turn 70.5 years old, regardless of employment status at this time. Specific plan sponsors may require their employees to begin receiving distributions before age 70.5 even if they have not yet retired.

Advantages

Participants in a DB plan have very little control over their benefit, which translates into very little responsibility required. In the United States, when employees are faced with making monthly investments, setting up employer-matching contributions, choosing which funds to invest in, and planning out how much money is needed to support a retiree from retirement to death (which are all true for defined contribution plans), they often choose to do nothing or do too little.

DB plans are administered by an outside company and are funded by the plan sponsor, taking nearly all of the responsibility out of the hands of the participant. In a basic DB plan, the only actions required by a participant are filing initial paperwork to enter the plan, keeping their employer updated of address changes even after they leave the company, and choosing a type of monthly payout upon retirement.

Criticisms

Although the performance of the pension's portfolio does not affect payments made to retirees, some critics of defined benefit plans argue that participants should have a higher degree of control over the investments. The most common argument for more control is that participants can't invest more in their plans if they want to. If a DB participant desires a higher post-retirement payout, he or she must take out a separate IRA or 401(k), if available.

DB plans require a participant to work for their employer for a set number of years in order to become vested in the plan, whereas retirement options such as defined contribution plans allow the participant to be 100% vested when they first open their plan.

Defined benefit plans also traditionally have no adjustments for inflation post-retirement. If a retiree is receiving $400 per month for the rest of their life, this amount will not increase even if the price index increases, reducing the real value of the $400.