Definition
A Defined-Benefit Plan is a type of retirement plan in which an employer promises a specified retirement benefit that is predetermined by a formula based on the employee’s earnings history, tenure of service and age. The employer typically funds the plan by contributing to a pool of funds set aside for this purpose. The actual payout depends not on investment returns, but on factors such as years of service and salary history.
Phonetic
The phonetic pronunciation of “Defined-Benefit Plan” would be: De-fined /dɪˈfʌɪnd/Benefit /ˈbɛnɪfɪt/Plan /plan/
Key Takeaways
- Guaranteed Retirement Income: Defined-Benefit Plans provide a specific, predetermined amount of income in retirement. This benefit is typically based on factors such as length of employment, salary history, and age.
- Employer Funded: Unlike Defined-Contribution Plans where you contribute your own money, Defined-Benefit Plans are primarily funded by the employer. The employer bears the investment risk and has the responsibility to make sure there are enough funds to meet future payment obligations.
- Protection from Market Fluctuations: Since the retirement benefit is pre-determined and funded by the employer, participants in Defined-Benefit Plans are not subject to the ups and downs of the investment market. This provides a level of financial security that is not found in Defined-Contribution Plans.
Importance
A Defined-Benefit Plan is a significant term in business/finance because it refers to a type of pension plan in which an employer guarantees a specific retirement benefit amount to an employee. Its importance lies in its ability to offer financial security to employees post-retirement. This plan’s benefits are generally calculated based on factors such as an employee’s salary history and tenure, which helps in retaining talent and incentivizing long-term service within the organization. Moreover, the associated investment risk and portfolio management is borne by the employer not the employee, protecting the latter’s interests. Therefore, understanding this term is crucial to both employers crafting benefits packages and employees planning for their financial future.
Explanation
The main purpose of a Defined-Benefit Plan is to provide a consistent and predictable income for employees post their retirement, ensuring financial security and stability. This type of plan is employer-sponsored, whereby the employer commits to pay a specified amount to the employees after their retirement, often based on their years of service and salary history. Consequently, the burden of investment risk and portfolio management falls on the employer, not the employees. It seeks to reward long-term employees by providing them with a calculated, predetermined retirement benefit, reducing their financial stress in their golden years.Uses of a Defined-Benefit Plan extend beyond simply providing a retirement benefit. It is a crucial tool employers use to attract, appreciate, and retain staff, thus promoting dedication and loyalty amongst their workforce. With the promise of a defined sum upon retirement, employees often feel more valued and appreciated, which could enhance their professional performance. Additionally, the policy serves to minimize the worry for employees about future financial uncertainties, thereby allowing them to direct their focus on their work in the present day.
Examples
1. The Federal Employees Retirement System (FERS) – U.S Federal Government: The FERS is an excellent example of a defined-benefit plan. Federal government employees are offered a pension as part of their benefits package. Their pension benefits are calculated based on their years of service and the highest average pay they received during any 3 consecutive years of service. After retirement, they receive a specific benefit payout regularly, the amount of which has been defined in advance.2. General Motors Pension Plan: General Motors, like many traditional manufacturing companies, offers a defined-benefit plan to its employees. The GM Pension Plan promises to pay their retired employees a fixed income which is determined based on their salary and years of service.3. California Public Employees’ Retirement System (CalPERS): CalPERS is a defined-benefit plan that provides retirement income to state employees of California. Similar to the other plans, the won retirement income is based on the employee’s years of service, age at retirement, and final compensation.
Frequently Asked Questions(FAQ)
What is a Defined-Benefit Plan?
A Defined-Benefit Plan is a type of pension plan where an employer/sponsor promises a specified pension payment, lump-sum or combination thereof on retirement that is predetermined by a formula based on the employee’s earnings history, tenure of service and age.
How does a Defined-Benefit Plan work?
In a Defined-Benefit Plan, the employer makes contributions to the plan and is responsible for making sure that there are enough funds to meet the future obligations to employees. The exact benefits that a retiree will receive are calculated using a formula which considers factors like salary, age, and years of service.
What are some potential benefits of a Defined-Benefit Plan for employees?
For employees, Defined-Benefit Plans provide a predictable and stable source of income upon retirement. These plans are not subject to market volatility, ensuring retirees receive the predetermined amount despite how investments perform.
How does a Defined-Benefit Plan differ from a Defined-Contribution Plan?
The principal difference is that the Defined-Benefit Plan provides a set amount of benefits for the retiree while in a Defined-Contribution Plan, the final amount received by the retiree depends on the performance of the investments made with the employee’s contributions.
Who bears the investment risk in a Defined-Benefit Plan?
It’s the employer or plan sponsor that bears the investment risk in a Defined-Benefit Plan. If the funds in the plan’s portfolio do not perform well, it’s the employer’s responsibility to make up the shortfall.
Can an employee outlive their Defined-Benefit Plan?
No. A key feature of a Defined-Benefit Plan is that it provides lifetime income to the retiree. Regardless of how long the employee lives after retirement, they will continue receiving the predetermined payment.
Can Defined-Benefit Plans be portable?
Generally, Defined-Benefit Plans are less portable than other types of retirement plans. While it is possible to roll over a Defined-Benefit Plan into another type of retirement account if you leave your job, it may not be the most beneficial options and could be complex.
Are Defined-Benefit Plans common?
While Defined-Benefit Plans were more common in the past, they have become less prevalent replaced by Defined-Contribution Plans such as 401(k) plans. This is due to the high cost and risk associated with guaranteeing a specific retirement benefit to employees by the employer.
Related Finance Terms
- Pension Plan
- Annuity
- Vesting Schedule
- ERISA (Employee Retirement Income Security Act)
- Fiduciary Duty
Sources for More Information
