What is a Defined Benefit Plan? How Does It Work?

A defined benefit plan is commonly called a pension plan. This plan offers guaranteed retirement benefits to the employees. Generally, this type of pension scheme is funded by employers for its employees with retirement pay-outs as per a set formula. This formula for calculating the pension considers the employee's age, salary, and his/her tenure with the organization.

Understanding Defined Benefit Plans

Qualified benefit or pension plans are known as defined benefit plans because both employees and employers know the formula to calculate retirement benefits ahead of time. The employers and employees use this formula to define and set the pay-outs of the pension scheme. Defined benefit plans are somehow different than retirement schemes like retirement savings accounts wherein the amount of pay-out depends on the investment returns. Key points about these pension schemes to consider are:

  • It is an employer-based pension plan that pays-out the benefits according to the factors like the salary of the employee and his/her length of employment.
  • A defined benefit plan is different than the defined contribution plan as in former the employer but not the employee is responsible for all the investment and planning risks.
  • Generally, the benefits are paid out as fixed monthly income like one lump-sum payment or an annuity.
  • The surviving spouse of an employee, who has passed away, often entitles pension benefits under this plan.

As employers are responsible for making the decisions of investment and managing it, thus it thinks about all the risks involved in planning and investment.

How Does a Defined Benefit Plan Work?

A defined benefit plan ensures certain benefits when a policyholder retires. How much you get depends on many factors including salary, age, and period of service with the organization.

Every year through pension statics benefits of the future that have to be paid from this plan are calculated, and ultimately it determines the amount that needs to be contributed to the policy to fund the projected pension amount. Generally, employers are the only contributors to this plan. However, defined benefit plans may require the contribution of the employees to the plan.

Before availing any right to get retirement benefits under a defined benefit plan, one may have to work for a certain number of years. This period is generally referred to as the vesting period. However, if one leaves a job before completing the vesting period as per the defined benefit plan offered by his/her employer, he/she may not get full retirement benefits from that plan.

How to Calculate Retirement Benefits?

Pension benefits under a defined benefit plan are calculated as per the formula. This formula can provide a set amount for each year one works for an employer or this formula can provide for a certain percentage of earnings. Many pension schemes calculate the retirement benefits by averaging the earnings of an employee in the last few years of his/her employment. By taking the average of specific percentage and then multiplying it with the number of service years of an employee provides the result.

How Are the Retirement Benefits from a Defined Benefit Plan Paid?

Most of the defined benefit plans allow its policyholder to choose how does he/she wants the benefits to be paid. The payment options that are commonly offered are as follows:

  • A Single Life Annuity: Under this, one gets a fixed benefit every month until he/she lives. After the death of the policyholder, no payments are made to his/her survivors.
  • A Lump Sum Payment: One gets the entire value of his/her plan in the form of a lump sum. There are no further payments that are made to the survivors when the policyholder dies.
  • A Qualified Survivor and Joint Annuity: The policyholder gets a fixed monthly advantage until he/she dies. The surviving spouse of the policyholder as well gets the benefits until he/she lives. The pension or retirement benefit to the spouse is equal to at least 50% of the benefits of the policyholder.

Selecting the right payment option is necessary as it may affect the amount of benefit that one ultimately gets. So, one should consider all the available options carefully and should compare the amount of benefit paid under every option.

Advantages of a Defined Benefit Plan

  • Secured Retirement: A defined benefit or pension scheme ensures guaranteed income post-retirement thus one can retire securely. One gets a regular income as per the pay-out option selected by him/her, so he/she does not have to worry about the day-to-day expenses. It gives a sense of safety as one keeps on getting the paycheques in his/her golden years.
  • The Payments of Defined Benefit Plan Are Not Affected by Fluctuations of Market: Despite the fluctuations of the investment market, one gets a defined regular income.
  • Tax Benefits for Employers: Since this plan is employer-specific, they get tax benefits.
  • Good Option to Provide Support to Spouse: The spouse continues to get the pay-outs even if the primary pension scheme holder dies.
  • Improved Employee Retention: At a certain level money and profile hike are not everything that an employee wants instead he/she wants something from which his/her family gets benefits. This is one such policy that you can offer to your employees. As per the data of various organizations, they have seen sudden improvement in employee retention after introducing a defined benefit plan for his/her employees.

Summing It Up!

It is never early to plan for retirement. Income through pension, public provident fund, investments, and personal savings can help one to achieve his/her dreams of living well after retirement. One can start this by finding out how much he/she will get from his/her defined benefit plan at the time of retirement. If an employer is providing this facility, it sends the receipt for the same every year, however, one should read the fine prints of that. Finally, one should remember that any defined benefit plan does not provide the cost-of-living adjustments, therefore, the benefits that look lucrative now can be worth lesser in the future because of inflation.      

Written By: PolicyBazaar - Updated: 21 January 2021
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