A defined-benefit plan is an employer-sponsored retirement plan that calculates employee retirement benefits using a specific formula. This formula takes into account various factors, including the employee’s length of service with the company and their salary history.
Key features of defined-benefit plans include:
- Employer Responsibility: In a defined-benefit plan, the employer is primarily responsible for funding and managing the plan. Employers make regular contributions to the plan to ensure that retirement benefits are available to eligible employees upon retirement.
- Benefit Formula: The retirement benefit that employees will receive is predetermined by a formula established in the plan’s documentation. This formula typically considers factors such as the employee’s years of service and average salary during their career with the company.
- Guaranteed Benefits: Defined-benefit plans provide employees with a guaranteed retirement benefit, which is typically based on a percentage of their average salary over a specified number of years of service. This benefit is often paid out as a monthly pension when the employee retires.
- Employer Contributions: Employers are responsible for making contributions to the plan to ensure that there are sufficient funds to meet the future retirement benefit obligations to employees. These contributions are typically actuarially determined to meet the plan’s funding requirements.
- Employee Vesting: Employees typically become vested in the plan after a certain number of years of service. Vesting means that they have earned the right to receive the retirement benefit upon retirement, even if they leave the company before reaching retirement age.
- Predictable Retirement Income: Defined-benefit plans provide employees with a predictable and stable retirement income, as the benefit amount is predetermined by the plan’s formula.
Defined-benefit plans differ from defined-contribution plans, such as 401(k) plans, where the retirement benefit depends on the contributions made by the employee and employer, as well as the investment performance of those contributions. In defined-benefit plans, the employer bears the investment risk, and employees receive a predetermined retirement benefit.
These plans have become less common in recent years, with many employers transitioning to defined-contribution plans due to the predictability of retirement costs and the shifting of investment risk to employees.