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A defined benefit pension plan is a type of retirement plan in which an employer allocates specific amounts of money for participating, vested employees in a tax deferred account.[1] The plan is "defined" because the formula for calculating the amount contributed by an employer is known in advance. Differing from a defined contribution plan, the benefits a retiree receives from a defined benefit plan (commonly referred to as a DB plan) are not dependent on the success or failure of the portfolio in which the employer's contributions are invested.[2] This distinction places the entire liability of economic market fluctuations and the particular portfolio's performance on the employer (or the plan sponsor). The benefit that a participating employee will receive is traditionally calculated based on length of employment and terminal wages.[3] In some instances, the management level of a participant will also factor into the calculation. Because of the plan's tax-deferred status, there are restrictions on how early benefits can be received.[3] The academic study of retirement is in the field of financial economics.


Calculation of defined benefit pension plans

Eligibility

To be eligible to receive benefits from a DB retirement plan, an employee must first work for an employer who is offering the plan. This is becoming much less common since the introduction of defined contribution plans in the 1980s, due to the decreased risk put on the employer by these plans.[4] Only about 10% of employees in the United States private sector have defined benefit plans, although 90% of state and local governments still offer the plans.[5][6]

Once an employee is hired, they must first meet participation requirements in order to join the plan. This is often either one year of employment with the plan sponsor or 1000 hours of service (about half a year of full-time employment).[7]

After joining, the employee (now a participant) must become vested in the plan or else they will not receive benefits upon retirement. Employers are permitted by law to require a participant to work at least 5 years before becoming 100% vested.[8] However in a graduated vesting schedule, the employer may require 7 years for 100% vested, but they must permit lower percentages of vesting for lesser years of service (such as 60% vested after 4 years of service).[8] Once vested, a participant can terminate their employment at any time and still receive benefits at retirement.

Calculation

The plan sponsor, while working with an outside company that is administrating the plan, can choose to calculate participants' benefits in several ways. In every type of plan, the final calculation is multiplied by the percent that the participant is vested.[8] If a participant did not meet the vesting requirements of their employer, then the final calculation is multiplied by 0%, resulting in no benefit. If the participant completed the years of employment requirement, then they are 100% vested and they receive the full calculated amount of benefit.

Unit credit formula

Benefits at retirement are determined by the years of service to the employer, either as a fixed percentage of compensation per year or as a flat-dollar amount per year.[9]

The former type (sometimes called final pay formula) is the most prevalent formula used and is typically based off the average of a participant's highest earnings for 5 consecutive years in the last 10 years of service.[10] This average is then multiplied by each year of service worked and the total amount is the participant's account balance.

The second type is very rare and it adds a specified dollar amount to the account balance for every year of service.[10] An example would be $35 per month multiplied by the number of years worked.

Fixed benefit formula

The monthly benefit is determined by a fixed percentage of the participant's compensation.[9] Much less common than the unit credit formula, this is based off of a participant's earnings over all years worked at the company.[10]

Flat benefit formula

Monthly benefits are a flat-dollar amount.[9]

Early or late retirement

Payouts available

A lump sum payment is the entire account balance that the plan sponsor has contributed to for a particular participant.[8]

If a participant's calculated account balance is less than $5,000 when they terminate employment with the plan sponsor, the sponsor is permitted to require a mandatory cash out.[8] In an MCO, a participant receives the full amount of their account balance (even if they haven't yet retired), but they do not receive any benefits upon retirement.

At retirement, the entire lump sum can be transferred into an IRA account if the participant desires, which would continue to be tax-deferred.[8]

Management of defined benefit plans

Duties of a plan administrator

Investment strategies

See also Investment

United States federal retirement laws

See also Federal retirement laws

A participant must begin receiving payments from their DB plan by April 1 following the year in which they turn 70.5 years old, regardless of employment status at this time.[8] Specific plan sponsors may require their employees to begin receiving distributions before age 70.5 even if they have not yet retired.

Advantages

Participants in a DB plan have very little control over their benefit, which translates into very little responsibility required. In the United States, when employees are faced with making monthly investments, setting up employer-matching contributions, choosing which funds to invest in, and planning out how much money is needed to support a retiree from retirement to death (which are all true for defined contribution plans), they often choose to do nothing or do too little.[11] DB plans are administered by an outside company and are funded by the plan sponsor, taking nearly all of the responsibility out of the hands of the participant. In a basic DB plan, the only actions required by a participant are filing initial paperwork to enter the plan, keeping their employer updated of address changes even after they leave the company, and choosing a type of monthly payout upon retirement.[8]

Criticisms

Although the performance of the pension's portfolio does not affect payments made to retirees, some critics of defined benefit plans argue that participants should have a higher degree of control over the investments.[12] The most common argument for this is that participants can't invest more in their plans if they want to. If a DB participant desires a higher post-retirement payout, he or she must take out a separate IRA or 401(k), if available.

DB plans require a participant to work for their employer for a set number of years in order to become vested in the plan, whereas retirement options such as defined contribution plans allow the participant to be 100% when they first open their plan.[8]

Defined benefit plans also traditionally have no adjustments for inflation post-retirement.[12] If a retiree is receiving $400 per month for the rest of their life, this amount will not increase even if the price index doubles, reducing the real value of the $400.

Combination pension plans

Cash Balance Plan

Money Purchase Plan

References

  1. ↑ Business Dictionary. ( n.d.). Definition of defined benefit plan. Retrieved from http://www.businessdictionary.com/definition/defined-benefit-plan.html
  2. ↑ Financial Dictionary. (n.d.). Definition of Defined benefit plan. Retreived from http://financial-dictionary.thefreedictionary.com/Defined-Benefit+Plan
  3. ↑ 3.0 3.1 Investopedia. (n.d.). Definition of defined benefit pension plan. Retreived from http://www.investopedia.com/terms/d/definedbenefitpensionplan.asp
  4. ↑ CNN Money. (n.d.). Am I eligible for a defined benefit plan? Retreived from http://money.cnn.com/retirement/guide/pensions_basics.moneymag/index6.htm
  5. ↑ CNN Money. (n.d.). Just how common are defined benefit plans? Retreived from http://money.cnn.com/retirement/guide/pensions_basics.moneymag/index7.htm
  6. ↑ CNN Money. (n.d.). What if I work for the government? Retreived from http://money.cnn.com/retirement/guide/pensions_basics.moneymag/index8.htm
  7. ↑ Beacon Capital Management Advisors. (n.d.). Defined Benefit Plans FAQs. Retreived from http://www.individual401k.com/defined_benefit_plans/faq.htm
  8. ↑ 8.0 8.1 8.2 8.3 8.4 8.5 8.6 8.7 8.8 United States Department of Labor. (n.d.). What You Should Know About Your Retirement Plan. Retreived from http://www.dol.gov/ebsa/publications/wyskapr.html
  9. ↑ 9.0 9.1 9.2 Waddell and Reed Financial Advisors. (n.d.). Employer Contribution. Retreived from http://www.waddell.com/personal_investors/products_retirement_sponsored.aspx
  10. ↑ 10.0 10.1 10.2 United States Bureau of Labor Statistics. (n.d.). Payment Options under Retirement Plans. Retreived from http://www.bls.gov/opub/cwc/cm20030409ar01p1.htm
  11. ↑ CNN Money. (n.d.). What are the advantages of a defined benefit plan? Retreived from http://money.cnn.com/retirement/guide/pensions_basics.moneymag/index9.htm
  12. ↑ 12.0 12.1 CN Money. (n.d.). What are the disadvantages of a defined benefit plan? Retreived from http://money.cnn.com/retirement/guide/pensions_basics.moneymag/index10.htm

Notes and links

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Further reading

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