What are defined benefit plans?
Defined benefit plans are employer-sponsored retirement plans that promise a certain benefit upon retirement. The size of the benefit is based on factors such as salary, age, and years of service with the company.
How do they work?
While employers contribute into defined benefit plans, employees usually do not. The amount the company contributes into the plan flows from projections made annually by actuaries based on the future benefits to be paid from it.
An employee will likely have to work a specific number of years before they have a permanent right to a retirement benefit under the plan. This is generally referred to as a plan's vesting requirement. If an employee leaves a job before accumulating enough service to be vested, the individual may not receive full benefits under the plan. Depending on the plan's rules, they may not receive any benefits. The retirement benefit received under a defined benefit plan is based on a formula, which may provide for a set dollar amount for each year of employment at the company, or a specified percentage of the employee's earnings.
How benefits are distributed
Many plans often provide options as to how benefits may be paid. Some of the most common choices include:
Less investment risk for the employee
Defined benefit plans may be fading from the scene, but they offer a retirement benefit that doesn't hinge on the performance of underlying investments. The risk of investment performance is borne entirely by the employer in its role as plan sponsor. In addition, most benefits are insured (up to a specified annual maximum) by the federal government through the Pension Benefit Guaranty Corporation.
Defined benefit vs. defined contribution
Defined benefit plans are distinguished from their defined contribution counterparts, where the primary focus is on contributions made by the employee, and perhaps the employer as well. But the latter isn't obligated to pay a specified amount in retirement. Instead, the amount the recipient is paid at retirement depends on contributions made, investments chosen by the employee or company from the choices offered by the plan, and how well those investments performed.
Some employers offer hybrid plans (or programs that contain some defined contribution–like characteristics), the most prominent of which is the cash balance plan. Cash balance plans are obligated to pay the recipient a specified amount at retirement, and are similarly government insured. On the other hand, similar to defined contribution plans, retirement funds effectively accumulate in a hypothetical individual account (funds are pooled; each employee's interest is maintained by bookkeeping entries). Upon leaving the employer, the individual can typically elect one of the following options:
- Receive a lump-sum distribution of the vested account balance.
- Roll it over to a new employer’s retirement plan.
- Transfer it to an individual retirement account (IRA).
- Remain in the plan.