What is a Defined-Benefit Plan?
A defined-benefit plan is an employer-sponsored retirement plan where employee benefits are computed using a predetermined formula that considers factors such as length of employment and salary history. Employees generally need to work for a specific duration before becoming eligible to participate in the plan and may need to wait after any breaks in service.
The employer is responsible for managing the plan’s investments and risks, often hiring an outside investment manager to oversee the plan. Unlike a 401(k) plan, employees cannot withdraw funds at will; they are acquainted with a fixed monthly payment similar to an annuity or, in some cases, a lump sum at a pre-defined retirement age.
Grasping the Concept of Defined-Benefit Plans
Known also as pension plans, this type of plan is termed “defined benefit” because both employees and employers can calculate the retirement benefit amount beforehand using the set formula. It stands in contrast to retirement savings accounts, where payouts depend on investment returns.
Poor investment returns or incorrect assumptions can lead to funding shortfalls, which employers must address with additional cash contributions.
Key Takeaways
- A defined-benefit plan is an employer-based program paying benefits based on factors like employment duration and salary history.
- Pensions are examples of defined-benefit plans.
- Unlike defined-contribution plans, the employer handles all planning and investment risks.
- Payouts can be in the form of fixed monthly payments (annuity) or a lump sum.
- Surviving spouses are typically entitled to benefits if the employee passes away.
Given the employer’s responsibility for investment decisions and management, they assume all associated planning and investment risks.
Exploring Defined-Benefit Plan Payouts
A defined-benefit plan guarantees a specific payout upon retirement. Employers can select either a fixed benefit or one calculated using a formula factoring in service years, age, and average salary. The employer funds the plan by regularly contributing a certain percentage of the employee’s pay into a tax-deferred account, though some plans allow for employee contributions as well. This employer contribution acts as deferred compensation.
Upon retirement, the plan may pay out monthly checks for the retiree’s lifetime or a lump sum. For instance, if a retiree with 30 years of service at retirement opts for a plan that offers $150 monthly per service year, they would receive a $4,500 monthly benefit. Should the employee pass, some plans distribute the remaining benefits to designated beneficiaries.
Choosing Between Annuity and Lump-Sum Payments
Payment options include a single-life annuity, providing fixed monthly benefits until death; a qualified joint and survivor annuity, which continues benefits to the surviving spouse; or a lump-sum payment representing the entire plan value.
Selecting the appropriate payment route is paramount, as it can drastically impact the received benefits. Discuss options with a financial advisor to ensure optimal benefit value.
Keep in Mind:
- Working additional years enhances your benefits by incrementing service years used in the calculation.
- Continuing employment past the normal plan retirement age can further increase potential benefits.
Related Terms: 401(k) plan, annuities, pension plans, tax-deferred accounts, lump-sum payments.
References
- Internal Revenue Service. “Defined Benefit Plan”.
- Internal Revenue Service. “Retirement Topics: Death”.
- Internal Revenue Service. “When Can a Retirement Plan Distribute Benefits?”
- Internal Revenue Service. “Annuities – A Brief Description.”
