Defined benefit plans are retirement plans that are largely funded by employers, with payouts based on a set formula that considers employees’ salary, age and tenure with the company. Also known as pension plans, they historically were offered to entice workers to stay with one company for years. But as lower-cost defined contribution plans arose, defined benefit plans became much less prevalent.
There’s no formula for how benefit plans are set — one may be based on an employee’s average salary for his or her career, while another may use a flat dollar benefit like $800 for each year an employee has been with the firm.
Often, however, the formula is more complex. A company might offer a plan that pays 1.5% of an employee’s average salary for the past five years of employment for every year at the company. That would mean that an employee who worked at the company for 20 years might receive a payment of 30% of his or her average salary over those years.
While employers generally get tax breaks for contributing to these plans, they have to provide guaranteed payments to beneficiaries, no matter how the underlying investments in a plan perform. With a 401(k) plan, future payments are reliant on unassured investment performance. Benefits in most defined benefit plans are protected, within limitations, by federal insurance provided through the Pension Benefit Guaranty Corporation.
The pluses and minuses
The big advantages of defined benefit plans include:
- Retirement paycheck security — Employee benefits are guaranteed in a defined benefit plan, offering employees the security of a regular paycheck in retirement.
- Protection from market fluctuations — No matter what the underlying investments do, the employee retirement benefit stays the same.
- Potential for spousal support — A spouse may be able to continue receiving guaranteed payments after the employee’s death.
- Employer tax benefits — Employers generally get a tax deduction for contributions to defined benefit plans. The IRS focuses primarily on the plan’s compliance with nondiscrimination requirements and ensuring the plan documents include all mandated statutory and regulatory provisions.
- Improved retention — Defined benefit plans can keep employees with a company for a long time as they wait to vest and earn the most retirement benefits.
The disadvantages include:
- No investment choice — Employees have no say in what their money is invested in.
- Time to vest — If a company requires an employee to stay for five years to vest and the employee leaves after three, all the money earned stays with the company.
- Lack of portability — The funds cannot be easily transferred when an employee switches jobs, like funds vested in a 401(k) can.
- Maintenance expense — Because they offer guaranteed payments regardless of market conditions, defined benefit plans are more expensive for employers to maintain.
Employers have a vested interest in designing and maintaining a retirement benefit program that balances the recruiting and retention benefits it generates with the costs incurred by and the financial liability imposed on the employer.
Finally, note that the laws and accounting rules surrounding defined benefit plans are exceptionally complicated, and both companies and covered employees should get professional advice regarding them.