Defined Benefit Pension Plan: What You Need to Know
A defined benefit pension plan is a type of retirement plan where an employer/sponsor promises a specific pension payment, lump-sum, or combination thereof, on retirement that is predetermined by a formula based on the employee’s earnings history, tenure of service, and age, instead of depending directly on the individual investment returns. Unlike defined contribution plans, the employer/sponsor underwrites the employee’s investment risk in the defined benefit plans. In this article, we’ll explore how defined benefit pension plans work, their key features, and their benefits.
How It Works
Under a defined benefit pension plan, the employer makes contributions towards a pool of funds set aside for an employee’s future benefit. The investments within the fund are managed by the pension fund manager. Upon reaching retirement age, the employee receives a set pension that is based on factors such as salary, years of service, and the age of the employee. The plan may offer a payment in the form of a lump sum or an annuity, which provides regular payments for as long as the retiree lives.
Key Features
The defined benefit pension plan has several characteristics that make it unique:
- Fixed Benefit: Once the employer and employee agree on a plan, the employee is guaranteed a fixed sum on retirement, regardless of how the fund’s investments perform.
- Employer’s Responsibility: The employer is responsible for managing the pension fund’s investment and ensuring that it can pay out the available pension upon retirement.
- Benefits based on salary and service years: The benefit a retiree is entitled to is determined by their salary and the number of years they have worked with the employer.
Benefits
One major benefit of defined benefit pension plans is they provide a predictable retirement income. Retirees don’t have to worry about outliving their retirement savings or their income reducing with changing investment markets. The payout remains consistent over the years. Additionally, financial planning becomes easier for the retiree, as they know how much income they should expect at retirement.
Enrollees of a defined benefit plan who have worked longer typically receive a higher pension than those with shorter work tenure, rewarding loyalty and longevity. If the plan allows for it, the pension can be shared with a spouse or beneficiary after the retiree’s death. This ensures financial security for the deceased retiree’s dependents.
The State of Defined Benefit Pension Plan
Despite their many advantages, defined benefit pension plans are less common than they were in the past. The increased longevity, the unpredictable nature of financial markets, and the high management costs have made these plans less attractive for employers. Many have transitioned to defined contribution plans, which place more investment risk on the employee.
There has been growth of ‘pension loans’ in countries like Australia, which allow those in pension plans to access a portion of their pension early as a loan. This strategy can provide financial flexibility for pensioners, but also carries the risk of reducing future pension payments and hence should be approached with caution.