Definition
A defined benefit pension plan is a type of pension plan in which an employer/sponsor promises a specified pension payment, lump-sum 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. Traditionally, many governmental and public entities, as well as a large number of corporations, provided defined benefit plans, sometimes as a means of compensating workers in lieu of increased pay.
Defined Benefit Plan
A pension plan where the employer “defines” a benefit on a monthly basis after retirement is known as defined-benefit plan. This type of plan differs from other pension plans as the employer does not depend upon the employee’s investment returns, and the benefit formula is known to the employee in advance.
The advantage of using this type of pension plan is that the employees are free from any responsibility, and don’t have to put in their own money into the plan.
This type of pension plan is more beneficial to the employee than the employer, since in case of a shortfall, the employer has to use the company’s earnings to fund the retirement of an employee. This is the reason why, in recent years, many companies do not offer a defined-benefit plan for their employee’s pension plans.
How does a Defined-Benefit Plan Work?
When an employee takes up a defined-benefit plan, the employer pledges to provide a specific sum of money every month to the employee for the rest of their life after they retire. In this plan, assets are contributed from the employer and/or members of the funded defined-benefit plan. In funded defined-benefit plan, the future benefits to be paid are unknown, since they depend on the funding. If the funding is low, the obligations of the payment of pension will not be met. Therefore, the risks and rewards are assessed by an actuary (hired by the employer) beforehand. Unfunded defined-benefit plans are also known as pay-as-you-go (PAYGO or PAYG) because no assets are set aside for it and the employer (or sponsor) simply pays the promised amount to the employee (or member) when the time comes. In the United States, this type of defined benefit plan is strictly prohibited by the Employee Retirement Income Security Act (ERISA).
Funded Defined-Benefit Plan
Unfunded Defined-Benefit Plan
Further Reading
