A defined-benefit plan is an employer-sponsored retirement plan where benefits are calculated on factors such as salary history and duration of employment. This article provides a comprehensive understanding of defined-benefit plans, their calculations, real-world examples, and payment structures.
What Is a Defined-Benefit Plan?
Defined-benefit plans, commonly known as pension plans, promise a specified monthly benefit at retirement. This benefit may be an exact dollar amount, such as $1,000 per month, or it may be calculated through a plan formula that considers factors like salary history and the number of years an employee has worked for the employer.
How Benefits Are Calculated
Under a defined-benefit plan, the retirement benefits are typically determined by a formula that often includes the following components:
- Final Average Salary (FAS): Usually an average of the employee’s highest or last few years of salary.
- Years of Service (YOS): The total number of years the employee has worked for the employer.
- Benefit Multiplier: A percentage used to determine the benefit amount, often ranging from 1.5% to 3% per year of service.
The formula can be represented mathematically as: \( \text{Annual Benefit} = \text{FAS} \times \text{YOS} \times \text{Benefit Multiplier} \)
Example Calculation
Consider an employee with the following details:
- Final Average Salary (FAS): $60,000
- Years of Service (YOS): 30 years
- Benefit Multiplier: 2%
The annual benefit would be calculated as:
Types of Defined-Benefit Plans
Traditional Defined-Benefit Plans
These plans provide a fixed, pre-established benefit typically paid monthly over the life of the retiree.
Cash Balance Plans
These are defined-benefit plans that are designed to resemble defined-contribution plans. Each participant has an account that grows annually based on a specific annual interest credit rate and employer contributions.
Special Considerations
- Vesting Period: The time an employee must work before gaining full rights to their pension benefits.
- Funding Risks: The employer bears investment risks. Insufficient funding can lead to plan underperformance, impacting retirees.
- Portability: Defined-benefit plans are less portable compared to defined-contribution plans since they are tied to the employer.
Historical Context
Defined-benefit plans were the primary retirement benefits offered by employers in the mid-20th century. However, their prevalence has declined due to high costs and the rise of defined-contribution plans like 401(k)s.
Applicability in Modern Workforce
Despite the decline, defined-benefit plans remain significant in public sector jobs, such as government positions and unionized industries.
Related Terms
- Defined-Contribution Plan: A retirement plan where the employer, employee, or both make contributions, and the final benefit depends on the plan’s investment performance.
- Pension: A regular payment made during retirement from an investment fund to which an employee and employer have contributed during employment.
- Vesting: The process by which an employee accrues non-forfeitable rights over employer-provided stock incentives or employer contributions to a retirement plan.
FAQs
How does a defined-benefit plan differ from a defined-contribution plan?
What happens if an employer goes bankrupt?
Are defined-benefit plans taxable?
References
- Pension Benefit Guaranty Corporation. “Understanding Benefits.” PBGC.gov.
- U.S. Department of Labor. “Types of Retirement Plans.” dol.gov.
- Financial Industry Regulatory Authority. “Defined Benefit Plans.” FINRA.org.
Summary
Defined-benefit plans offer a structured and reliable retirement income, making them a valuable benefit for long-term employees. Understanding the intricacies of these plans, including how benefits are calculated and paid out, is crucial for effective retirement planning.
