Defined Benefit Plans – Planning for Retirement Income
posted by Fisher 401(k) March 2, 2020
What is a defined benefit pension plan?
A defined benefit pension plan is a retirement plan that promises a specified, or "defined," payment at retirement based on an actuarial calculation using the employee's length of service, age and compensation.
What is the difference between a defined benefit pension plan and a defined contribution plan?
A defined benefit plan is not like a 401(k) or other defined contribution plan, which may specify how much is contributed into the plan for each participant but leaves the actual amount available for retirement unknown and dependent on individual contributions and investment returns. A defined benefit plan is funded by the employer but may require a percentage of an employee’s pay to be deferred into the plan. No matter how contributions are made, the employer is responsible for managing the plan's investments and making sure the plan meets the funding requirements necessary to pay the promised benefits. If a plan becomes underfunded because investments do not grow at the anticipated rate needed to fund the plan’s obligations, the employer is responsible for making up the shortfall. Employees generally have to work for a certain number of years to be fully vested.
Individuals who participate in a defined benefit plan may also contribute to a 401(k) plan of the same or a different employer.
Defined benefit plan benefit limit
Because employers must ensure that a defined benefit plan is funded to satisfy the benefits promised to employees in retirement, there are no limits on contributions. However, pension payments made to retirees are subject to a cap. An individual’s benefit is determined by a formula set by the plan. A simple formula, for example, might base pension payments on a percentage of an employee’s average earnings during the last five years of employment prior to retirement. Starting January 1, 2020, the cap on the annual benefit from a defined benefit plan is $230,000.1
Can you withdraw money from a defined benefit plan?
A defined benefit plan specifies a normal retirement age, which is when employees will be eligible to receive their full accrued benefit. A plan may permit earlier distributions at a certain age or when employment is terminated. Payment options typically include a lump sum payment, but the primary benefit of a defined benefit plan is typically the periodic payment (usually paid monthly) that is guaranteed for the employee’s life, or over the lives of the employee and their spouse.
What are the benefits of a defined benefit plan?
A defined benefit plan promises a lifetime flow of income to long-term employees after they retire, which is an important benefit for attracting and recruiting employees. A defined benefit plan can be more expensive to fund and maintain than a defined contribution plan. And although employers may deduct plan contributions, the employer bears all the investment risk.
According to the Bureau of Labor Statistics, as March 2017, 63% of private industry workers participating in defined benefit retirement plans were in plans that were open to new participants. 25% of workers were in soft-freeze plans, or plans that no longer allow new employees to participate but allow all or some workers in the plan to continue accruing benefits. The remaining 12% of workers were in frozen, or hard-freeze plans.