Definition
A Defined Benefit Plan is an employer-sponsored retirement plan where the benefits that an employee will receive upon retirement are predetermined and calculated based on variables such as salary, age, and tenure of service. The employer bears the investment risks and is responsible for ensuring the necessary funds are available at the time of the employee’s retirement. This is unlike a Defined Contribution Plan where the retirement benefits depend on the investment’s performance.
Key Takeaways
- A Defined Benefit Plan is a type of pension plan in which an employer/sponsor promises a specified monthly benefit on retirement that is predetermined by a formula based on the employee’s earnings history, tenure of service and age, rather than depending directly on individual investment returns.
- Unlike defined contribution plans, the risk in a defined benefit plan lies with the employer not the employee, as the employer is responsible for making sure there are enough funds to deliver the benefits promised.
- Defined Benefit Plans are insured by a federal agency called the Pension Benefit Guaranty Corporation. However, if a plan becomes insolvent, the PBGC may not be able to cover 100% of the promised benefits.
Importance
The finance term “Defined Benefit Plan” is important as it refers to a type of pension plan in which an employer promises a specified monthly benefit on retirement that is predetermined by a formula based on the employee’s earnings history, tenure of service, and age.
Unlike defined contribution plans where the payout depends on the returns of the invested funds, the payout in a defined benefit plan is certain and thus offers security to retirees.
The risk of investment is borne by the employer.
These plans are significant in attracting and retaining employees, providing them with predictable income in their post-employment years.
Explanation
The purpose of a Defined Benefit Plan, also known as a pension plan, is to provide employees with a predictable, steady income source after they retire. These plans are typically funded by the employer, and the benefits are calculated based on factors such as salary, age, and the number of years the employee worked for the company.
Pensions offer financial security to retirees and can be particularly valuable for employees who spend a long time at a single company. They help retain and reward long-term employees by offering them a stable financial future.
The Defined Benefit Plan is used to attract and retain quality employees, creating a motive for them to remain in the company for a longer duration. This type of plan reassures employees about their long-term financial security, as the burden of contributing and managing the investment risks lies with the employer.
Accordingly, it not only serves the employees but also benefits employers by fostering employee loyalty and reducing turnover. Therefore, a Defined Benefit Plan plays a critical role in employees’ retirement planning and the employer’s personnel strategy.
Examples of Defined Benefit Plan
Teacher Retirement Systems: Many educational institutions provide Defined Benefit Plans to their teachers and professors. After a certain number of years of service, educators can retire with a certain percentage of their salary provided annually as retirement income. The exact benefit is often calculated based on their final average salary and years of service.
Government Employees Retirement System: Federal, State, and local government sectors often provide Defined Benefit Plans to their employees. For example, the Federal Employees Retirement System (FERS) in the U.S provides retirement benefits for all employees. The plan is funded by both the employees’ and government’s contributions during their employment, and the benefit is defined based on years of service and the employee’s salary at the time of retirement.
General Motors Pension Plan: Many corporations, like General Motors, have defined benefit plans for their employees. In this specific example, General Motors provides a defined benefit pension plan that pays employees a specific annual benefit at retirement. The benefit is funded by the corporation and calculated based on an employee’s salary and years of service.
FAQs for Defined Benefit Plan
What is a Defined Benefit Plan?
A Defined Benefit Plan is a type of pension plan in which an employer promises a specified monthly benefit on retirement that is predetermined by a formula based on the employee’s earnings history, tenure of service and age, rather than directly depending on individual investment returns.
What are the benefits of a Defined Benefit Plan?
The primary benefit of a Defined Benefit Plan is that it guarantees a specific retirement benefit amount, regardless of investment performance. This gives plan participants predictability and stability for their retirement income.
Who contributes to a Defined Benefit Plan?
Usually, employers are the main contributors to Defined Benefit Plans. However, some plans may allow employees to contribute as well.
How is the retirement benefit calculated in a Defined Benefit Plan?
The retirement benefit of a Defined Benefit Plan is typically calculated using a formula that takes into account factors such as salary, years of service, and age at retirement. Each plan may have its own specific formula.
Are Defined Benefit Plans insured?
Yes, Defined Benefit Plans are insured by the Pension Benefit Guaranty Corporation (PBGC), a federal agency. If a Defined Benefit Plan is terminated because it’s underfunded, the PBGC will step in to pay pension benefits up to certain limits.
Related Entrepreneurship Terms
- Pension Fund
- Annuity
- Employer Contribution
- Vesting Period
- Funded Status
Sources for More Information
- Internal Revenue Service (IRS): This U.S. government agency provides detailed information about Defined Benefit Plans as part of tax and retirement guidance.
- U.S. Department of Labor: This department has relevant information for employers and employees pertaining to Defined Benefit Plans in its section on retirement plans, benefits, and savings.
- Investopedia: This is a respected source for a wide range of financial terms and concepts, including Defined Benefit Plans.
- Social Security Administration: This agency has resources relevant to retirement planning and benefits, including information on Defined Benefit Plans.
