What is a defined benefit plan? (Definition and benefits)
Updated 21 August 2023
A defined benefit plan offers guaranteed retirement benefits for employees. Although less common than defined contribution plans, defined benefit pension schemes offer security and retirement certainty for recipients. Learning about this type of retirement plan can help you determine how your pension works or whether it's suitable for the business to implement. In this article, we discuss what a defined benefit pension scheme is and how it works, outline the different types of defined-benefit plans and payment methods and list the advantages of this type of retirement plan.
What is a defined benefit plan?
A defined benefit plan is a qualified employer-sponsored retirement plan where pay-outs are based on a set formula that considers the employee's length of employment, salary history and age. The predetermined formula means that it guarantees a specific benefit or pay-out upon retirement. The employer is responsible for managing the plan's investments and risks.
They also ensure there's enough money in there for the time you retire. Employers historically used defined benefit pension schemes to encourage employees to stay at one company for years. Employees cannot withdraw funds from a defined benefit pension scheme as they can only access it as fixed-monthly payments annuity or as a lump sum payment at an age defined by the plan's rules.
How does a defined benefit pension scheme work?
This plan is called a defined benefit because employers and employees know the formula for calculating retirement benefits in advance. Employers may consider the factors such as an employee's tenure, age or average salary when creating a formula. They contribute a regular amount, based on a percentage of the employee's pay, into a tax-deferred account. Employees can also make contribution payments to this account known as deferred compensation.
Upon retirement, the employee may receive monthly payments from the account throughout their lifetime, in salary-like payments, or receive it as a lump sum payment. An example of a defined benefit pension scheme in action is as follows. A company might offer a defined benefit pension scheme that pays 2% of your average salary for the last three years of your employment for every year you worked at the company. This means that, if you work at the company for ten years, you may receive payments worth 20% of your average salary over those years.
Different types of defined benefit pension schemes
There are two main types of defined benefit pension schemes employees can receive and these include:
A pension is a guaranteed monthly benefit that you receive upon retirement. Employers base pension payments on a formula that considers how long you worked for a company and how much you earned during that time. It's typically necessary for employees to remain with a company for a certain period before earning pension benefits.
Once you've worked for the company for the set period, you become vested. Vesting requirements may vary, but it usually means that an employee vests, or owns, a certain percentage of their account in the pension. For example, working for a company for one year may mean that you're 10% vested. This means you're granted retirement payments equal to 10% of a full pension.
Cash balance plans
Cash balance plans grant employees a set account balance upon retirement or upon leaving the company, rather than set monthly payments. This means employees aren't guaranteed indefinite benefit payments throughout their lifetime but instead up to a certain cash balance. Cash balance plans calculate benefits according to your total working years with a company rather than just your highest or last earning period. This results in fewer benefits if the employer switches from a pension plan to a cash balance plan.
Employers are still responsible for all plan investments and risks. Employers calculate the set account balance amount based on interest credits and pay credits. An employee's account usually receives pay credits each year, such as 2.5% compensation from their employer. They then receive an interest credit on top of this based on the amount inside the account. Cash balance recipients receive an annual account balance each year once they become vested. They can choose whether to receive payments as a lump sum or in annuity form.
Defined benefit pension scheme payment methods
There are different ways you can receive payments from your defined benefit pension scheme. Learning these payment methods can help you determine the best option for you. Some payment methods include:
Single life annuity
Single life payments provide an employee with fixed monthly benefits throughout their lifetime and up until death. Your beneficiaries receive no further payments when you die. This payment option is similar to receiving salary payments at the end of each month which many are familiar with. This makes it easier to manage expenses. Single life payments are commonly associated with pension plans.
Qualified joint and survivor annuity
This payment method allows you to receive monthly benefit payments until death. It has the added benefit of allowing your surviving spouse to continue receiving these benefits thereafter. Your spouse receives monthly payments for the rest of their life that are equal to 100% of your original single-life annuity. They can also choose to receive the annuity as a lump-sum payment in which they receive the entire plan value in a single pay-out.
Single life with term certain
Single life with a term certain allows you to receive monthly payments for a specified period. If you pass away before the specified term is over, your spouse or other beneficiaries can receive payments. They receive these payments for a preset number of years as defined in the plan agreement.
50% joint and survivor
This payment option allows surviving spouses to receive monthly payments upon the death of the plan recipient. They receive these payments for the rest of their life. The payments are only equal to 50% of the original annuity.
A lump-sum payment allows you to gain immediate access to all the cash in your pension or cash balance plan. It involves receiving all benefits within one single payment. Lump-sum payments are a common choice when the employee is in poor health and expects a short retirement.
Defined-benefit plan advantages
There are several benefits to defined-benefit plans, including:
Spousal support: Some defined benefit pension schemes make it possible for your spouse to continue to receive guaranteed payments after you die. This gives you peace of mind that your family has the necessary security.
Improved retention: Employers require employees to work for the company for a set period before receiving retirement benefits. This helps increase retention rates as employees remain at the company to become fully vested and earn the most retirement benefits.
Retirement paycheck security: Defined benefit pension schemes offer employees a regular paycheck in retirement, thereby guaranteeing security.
Employer tax benefits: Employers can receive tax deductions for contributions or investments they make into defined benefit pension schemes. This provides them with higher revenues that they can invest back into the business.
No Market fluctuation interruptions: Market fluctuations don't affect defined benefit payments. This means that, no matter what happens to underlying investments, the employee retirement benefits remain the same.
Related: How to negotiate a better salary
Defined benefit pension scheme vs. defined contribution plan
Defined contribution plans are a newer benefit option in comparison to defined benefit pension schemes. This means that they're a lot more common among employers nowadays. Defined benefit pension schemes require employers to make most of the contributions to a retirement plan while defined contribution plans expect employees to make the most financial contributions. With defined contribution plans, employers can choose to provide matching contributions to those employees make. Defined contribution plans aren't guaranteed because they're dependent on the performance of underlying investments and the employee's contributions.
This differs from defined benefit pension schemes where monthly payments or lump-sum pay-outs are generally guaranteed depending on how long you remain at the company and your salary earnings. This means that defined benefit pension schemes offer greater assurance of returns, thereby making them a more reliable source of future income. Yet some employees prefer defined contribution plans as they give them more control when it comes to managing their retirement funds, allowing them to achieve higher earnings based on how much money they choose to invest.
Defined benefit pension scheme calculation example
Here's an example of a defined benefit pension scheme to facilitate better understanding:
Marcus starts a career average scheme on 1st April 2020 and has a pensionable salary of £30,000. Marcus banks £526.32 as a future pension income in his first year. This company works this out using the formula:
£30,000 x 1/57th = £526.32
The company now wants to calculate Marcus's future pension income for his second year. They do this by taking the first year amount of £526.32 as the opening balance. The company first adds an interest amount to this figure based on a 3% rate. They do this using the following formula:
£526.32 x 0.03 = £15.79
This means Marcus now has £542.11 in his pension account. His pensionable salary remains at £30,000 for the next year, meaning that he adds another £526.32 to his account. At the end of year two, Marcus thus receives £1,068.43.
Disclaimer: The model shown is for illustration purposes only, and may require additional formatting to meet accepted standards.
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