Defined Benefit Pension Plans
Whenever a person from the baby boomer generation hears the term pension plan, they refer to defined benefit pension plans. Defined benefit pension plans were the predominant type of pension plan just a few decades ago. In the 1980s, defined benefit plans accounted for over 80% of all types of pension plans which were offered to employees. However, over the years, companies have started moving from defined benefit to defined contribution plans. Today, less than 10% of all companies offer defined benefit pension plans.
In this article, we will have a closer look at what defined benefit plans are as well as some of the pros and cons of these types of plans.
What is a Defined Benefit Pension Plan?
A defined benefit pension plan uses a pre-determined formula to arrive at the pension amount which will be paid to an employee. This formula generally considers factors such as the employees age, last drawn salary, and overall tenure at the company. It is important to note that the formula to determine these benefits is not standardized. Instead, it could vary within different organizations.
The pension plan is created in such a way that employees are incentivized to stay at the same job for many years. Pension plans were one of the reasons that baby boomers spent most of their careers working at the same company.
In a defined benefit plan, the employer receives a tax deduction when they make payments towards the pension plan. Unlike defined contribution plans where both employer and employee make payments towards the plan, in this case, only the employer is supposed to contribute money.
The employers then invest this money to create a fund from which benefits are paid out. However, the amount of money that employers pay out is not related to the actual value of the investments. If the investments are in loss, then the employers are supposed to pay the difference to the employees from their own funds. This is the distinguishing feature of defined benefit plans. It is one of the reasons that employers prefer defined contribution plans over defined benefit plans.
The employers also have to pay a certain amount towards insurance premiums in order to insure the pension within certain limits. For instance, in the United States, the Pension Benefit Guaranty Corporation (PBGC) provides insurance to defined benefit plans.
Types of Defined Benefit Pension Plans
There are various types of defined benefit pension plans which are available in the market. The details relating to some common variations have been mentioned below:
The Concept of Vesting
When it comes to defined benefit plans, it is very important to understand the concept of vesting. Not every employee is eligible for a pension plan if the company is offering a defined benefit pension plan. Employees have to work a certain number of years before they are eligible to receive pension benefits.
The number of years that an employee has to work in order to be eligible for the benefits is called a vesting schedule. For instance, some companies may offer a 20% pension for every completed year of service. Hence, the pension will start vesting at the end of the first year. At the end of the first year, the pension would have vested 20%. The vesting will continue till the fifth year after which the employee will be eligible for a 100% pension.
Some plans only allow the employee to receive their benefits if they retire from the firm. However, there are other companies that allow employees to take the cash balance due in their plan if they decide to leave the company.
The concept of defined benefit plans is almost obsolete as of now. Very few companies still prefer to use this plan and still fewer plans to continue it in the future.
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