What Is a Defined Benefit Plan?
A defined benefit plan is a type of retirement plan in which an employer promises to pay retirees a certain amount each month.
This is regardless of how much they have contributed to the plan or how well the investments in the plan have performed.
The monthly payment amount is determined by a formula that considers factors such as years of service and salary history.
Defined benefit plans are also known as pension plans. These plans have several limitations that we'll touch on, and a sustainable 401(k) plan could be a better option for your company.
How Does a Defined Benefit Plan Work?
When a defined benefit plan covers an employee, the employer agrees to make regular payments into the plan on behalf of the employee.
These contributions fund investments, providing the money needed to pay out the benefits.
The size of an employee's monthly payments in retirement is determined by a formula that considers factors such as years of service and salary history.
It is important to note that defined benefit plans differ from defined contribution plans, such as 401(k)s, in which the amount of money an employee will receive in retirement depends on how much they have contributed.
It will also depend on how well the investments in the plan have performed.
What Are the Advantages of a Defined Benefit Plan?
There are several advantages of defined benefit plans, including:
Guaranteed Income in Retirement
Because a formula determines the payments, employees know exactly how much income they will receive in retirement.
Protection Against Inflation
The payments are usually adjusted for inflation, so retirees can maintain their standard of living even as the cost of living goes up.
Employer-Funded
With a defined benefit plan, the employer is responsible for contributing to the plan. This can be an employee advantage, especially if the employer offers a matching contribution.
What Are the Disadvantages of a Defined Benefit Plan?
There are also some disadvantages to defined benefit plans, including:
Complexity
These types of plans can be complex and expensive to administer.
Risk
The employer bears the risks associated with defined benefit plans. If the investments in the plan perform poorly or if there are more retirees than expected, the employer may have to make up the difference.
Lack of Portability
Defined benefit plans often do not allow employees to take their benefits with them if they leave their job before retirement.
Defined Benefit Plans vs Defined Contribution Plans
As we mentioned earlier, defined benefit plans differ from defined contribution plans.
With a defined contribution plan, such as a 401(k), the employee contributes a certain amount of money to the plan each month. The employer may also make contributions, but the amount is not guaranteed.
The employee bears the investment risk and responsibility for the plan. The amount of money the employee will receive in retirement depends on how much is contributed and how well the investments perform.
With a defined benefit plan, the employer bears the investment risk and responsibility for the plan.
The amount of money the employee will receive in retirement is determined by a formula and is not dependent on how well the investments in the plan perform.
So, which type of plan is better?
There is no easy answer to this question. Defined benefit plans offer the security of a guaranteed income in retirement, but they can be complex and expensive to administer.
Defined contribution plans are simpler and usually less expensive to administer, but the amount of money an employee will receive in retirement is not guaranteed.
It ultimately depends on the needs and preferences of the employer and employees.
Examples of Defined Benefit Plans
There are different defined benefit plans, each with rules and regulations. Examples of defined benefit plans include:
Pension Plans
A pension plan is a retirement savings plan sponsored by an employer. Pension plans can be either defined benefit or defined contribution plans.
401(k)s
401(k)s are a type of defined contribution plan. Employees can have a portion of their paycheck deducted and deposited into their 401(k) account.
Individual Retirement Accounts (IRAs)
IRAs are retirement savings accounts that anyone can open. There are two types of IRAs: traditional and Roth.
With a traditional IRA, employees can deduct their contributions from their taxes. With a Roth IRA, employees do not get a tax deduction for their contributions, but the money grows tax-free.
Deferred Compensation Plans
A deferred compensation plan is a type of retirement savings plan that allows employees to defer paying taxes on a portion of their income.
The money is invested and grows tax-deferred until it is withdrawn, at which point it is taxed as income.
There are many other retirement savings plans, such as 403(b)s and annuities. These are just a few examples of defined benefit plans.
The Bottom Line
A defined benefit plan is a retirement savings plan in which an employer agrees to make regular employee payments after retirement.
A formula determines the payment amount, and the employer bears the investment risk and responsibility for the plan.
Defined benefit plans can be complex and expensive to administer, but they offer the security of a guaranteed income in retirement.
Pension plans, 401(k)s, IRAs, and deferred compensation plans are all examples of defined benefit plans.
Employees who participate in defined benefit plans do not have the same level of flexibility as those with defined contribution plans.
For example, they may not be able to take their benefits with them if they leave their job before retirement.
FAQs
1. What is a defined benefit plan?
A defined benefit plan is a retirement savings plan in which an employer agrees to make regular employee payments after retirement. The amount of the payment is determined by a formula, and the employer bears the investment risk and responsibility for the plan.
2. How does a defined benefit plan work?
With a defined benefit plan, the employer agrees to make regular employee payments after retirement. A formula determines the payment amount, and the employer bears the investment risk and responsibility for the plan.
3. What are the benefits of a defined benefit plan?
Defined benefit plans offer the security of a guaranteed income in retirement, but they can be complex and expensive to administer.
4. What are the disadvantages of a defined benefit plan?
Defined benefit plans can be complex and expensive to administer, and employees who participate in them have a different level of flexibility than those with defined contribution plans. For example, they may not be able to take their benefits with them if they leave their job before retirement.
5. What are some examples of defined benefit plans?
Pension plans, 401(k)s, IRAs, and deferred compensation plans are all examples of defined benefit plans.
