Definition of Defined Benefit Plan:
Defined benefit plans are traditional pension plans that are sponsored by the employer. The employee can choose to receive a pension post retirement or can convert it into a lump sum amount, depending on their years of service, age, and other factors. There’s no single formula or method to calculate employee benefits. It might depend on the employee’s average salary, or a flat dollar benefit for each year.
Both employers and employees enjoy tax benefits on the amount they receive. Employers have to provide these guaranteed benefits, thereby making it different from 401(k)s where the future payments depend on the investment performance. Also, this benefit is protected by the Pension Benefit Guaranty Corporation.
Defined Benefit plan payment methods
Employees can either opt to withdraw the entire amount or receive a regular annuity for the rest of their lives. This annuity can be designed in multiple ways.
- Single payment for life. Here, retired employees receive a monthly payment for their lives until death. Their beneficiaries will not receive payments after their death.
- 50% joint and survivor. Here, the surviving spouse will get an amount every month for the rest of their life, which is equal to 50% of the original annuity amount.
- 100% joint and survivor. The surviving spouse will receive the monthly amount, which is 100% equal to the annuity amount.
Advantages of Defined Benefit plan
- Provides a financial security post retirement.
- Since employees are guaranteed a fixed amount, it is not affected by market fluctuations.
- Gives financial support to the spouse after the employee’s death.
- Provides tax benefits to employees for their contribution defined benefit plan.
- Improves the retention rate of the company, as they wait to reap the benefits.
Disadvantages of Defined Benefit Plan
- Employers usually invest the money themselves. Employees do not have a say in that.
- It forces the employee to stay at the company to vest the benefit.
- It becomes difficult to move the money as the employee changes jobs.
- It does not give employees an opportunity to increase their benefit.
- Employers have to pay their employees, even if the contributed/invested amount is not performing well in the market.