Defined Benefit Plan

What is a Defined Benefit Plan?

A defined benefit plan provides an employee with a set amount of money in the form of an annuity once retirement kicks in.  The amount of compenstation is typically based on a few factors such as duration of employment with the company and salary history as of retirement.  Employees who opt for early retirement will receive a lower monthly amount to compenstate for the longer duration of future benefits.

Upon determing retirement benefits, the employer must now fund the defined benefit plan.  Employers will fund an account in which they will be able to make investments to meet the goals of the eventual monthly payments to the employee.  Investment risk and management are at the discretion of the company; however, the retirement benefit to the employee will not be at risk.

Actuaries are employed to project future earnings potential and potential investment returns in the investment account.  This will allow the employer to understand how much they need to fund the defined benefit plan account with. 

Why are Fewer Companies offering Defined Benefit Plans?

In recent years, the availability of a defined benefit plan for employees has dwindled significantly as the costs to offer this plan are the highest among any of the retirement plan options an employer can offer.  Additionally, it is a very complex instrument to manage administratively.  Corporations may also be hit with an excise tax if the minimum contribution requirement is not met.  Additionally, setting up a defined benefit plan is a long term requirement for a corporation in order to receive the tax benefits that are associated to it. 

Typically, companies who offer these plans have long term, dependable streams of income which enable them to virtually guarantee contributions into this plan.

What is the difference between a defined benefit plan and a defined contribution plan?

Defined contribution plans are your typical 401(k) plans.  The key difference between the defined contribution plan and defined benefit plan is that a defined contribution plan provides no guarantees as to the your final retirement balance would be.  The returns in a defined contribution plan are tied to the contributions that were made to that account and the investment returns yielded on those contributions. 

As we stated above, the defined benefit plan is what people typically think of as a pension plan.  There are guaranteed payments at retirements and do not require employee contributions to this plan.

Another key distinction to make here is that defined benefit plans place the investment risk in the employers hands, while the defined contribution plan places the risk in the employee's hands. 


Tim Ord
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