Defined benefit plans are a form of retirement plan that used to be the norm in the United States. Pension plans are a form of defined benefit. Currently fewer than one in five employees is covered by a defined benefit plan.
Most employees are covered by defined contribution plans, such as 401(k)s and 403(b)s. Defined contribution plans specify what can be put into the plan each year. The output from the plan in retirement will be the result of investment performance; there is no way to accurately predict the precise amount an employee will get. The employee bears the investment risk.
Defined benefit plans used to be popular. But companies could sometimes realize a windfall by terminating the plan, a practice that was outlawed. Employers bore higher costs and greater risks with defined benefit plans, leading to a decline in their application over time.
Though less common than they were, defined benefit plans are by no means uncommon. Many union workers and other employees have defined benefit plans. They are still common in some fields, such as teaching.
Overview of Defined Benefit Plans
Pensions are the most common form of defined benefit plan. In a pension, a monthly payout is in advance for an employee. It is typically based on several factors.
Most pensions use a final average salary (FAS) as the income basis for the payout. An employee’s FAS is typically the average of their earnings over the last three or five years of their employment.
An employee’s length of service is also a factor. A typical pension formula provides a percentage of the employee’s FAS for each year of service.
A pension factor is used to translate FAS into a pension amount based on length of service. For example, an employer might use a 1.5 percent pension factor for each year of service. An employee with a FAS of $50,000, and 40 years of service when retiring at age 65 would receive a pension of $30,000 per year upon retirement. This is calculated by multiplying the pension factor times years of service, which yields 60 percent, then applying that to the FAS of $50,000, yielding $30,000 per year.
Most pensions are calculated based on a standard retirement age of 65. Employees retiring earlier would see a reduction in their benefits.
The base pension benefit is also based on a straight life annuity payout. There are typically several options available to the employee at retirement.
Employees approaching retirement typically need to make an election for how to receive payout from a defined benefit pension plan. There are options that will provide additional benefit to the employee in certain circumstances, but these come with the cost of reduced core benefit.
Straight Life Annuity: A straight life payout is typically the highest monthly payout available to the employee. The employee receives the benefit for as long as they live, with no benefits paid after their death. This works well if the employee lives to a ripe old age and has no dependents. It does not work well when the retiree passes early and leaves dependents who relied on that income.
Life with Term Certain: A life with term certain payout also provides a level monthly benefit for as long as the employee lives, but not less than a certain period.
This could be 10 years or 20 years, depending on the options available and the employee’s selection.
For example, if an employee selected a life payout with a 20-year term certain and died 7 years into retirement, the beneficiary would continue to receive the payments for another 13 years, the remainder of the 20-year certain period.
Joint and 50 percent survivor: A Joint and 50 percent survivor benefit pays a base benefit while the employee lives in retirement but continues the benefits at 50 percent to a surviving spouse after the retiree’s death.
Joint and 100 percent survivor: A joint and 100 percent survivor works like the joint and 50 percent example above, except that the payout continues at 100 percent instead of 50 percent.
In each case, there is a cost to getting these additional benefits. The straight life benefit provides the highest monthly payment but leaves nothing for dependents when the retiree passes.
There are numerous other possibilities, often forms or combinations of those above. The specific options a prospective retiree gets to choose from are available from their employer.
In some cases, employees will have a lump-sum option available. This is the actuarial value of the funds needed to provide for their annuitized pension benefit. In times of low interest rates, lump-sum payouts are relatively higher; in times of high interest rates, lump-sum payouts are relatively lower. Taking a lump-sum payout shifts the risk to the employee, who must then invest the proceeds to generate their own income. Though there is greater risk, this can be an attractive option in some cases.
The Bottom Line
Defined benefit plans are in use and still serve a needed purpose. There’s certainly an attractiveness to having an income you cannot outlive. Proving employees with the option to fund their retirement also provides them with the option to not fund their retirement. Defined benefit plans are typically 100 percent employee funded, and an employee will earn their benefit simply by virtue of employment. There’s no opt-out, and no one left out.
Defined benefit plans were — and are — more costly for the employer. Having fewer defined benefit plans has shifted the retirement funding burden to employees, and many individuals are not doing enough to prepare for their eventual retirement. Defined benefit plans provide a guaranteed income in retirement, something many people would want if it were still an option.