A defined-benefit plan is a retirement arrangement in which an eligible retired employee receives specified payouts from his former employer throughout retirement. The employer is responsible for managing the money to be able to make these pension payments, so there is some chance that promised benefits could be reduced.
Defined benefit pension plans typically pay retirees a monthly benefit for the rest of their life. Additionally, the investment risk of the plan is shouldered by the employer instead of the employee.
There are several different kinds of defined benefit formulas, but most of them fit into several key categories:
1) Final average pay plan 2) Career average pay plan 3) Dollars times service plan 4) Cash balance plan 5) Flat dollar benefit plan
Final Average Pay Plan In a final average pay arrangement, employees accrue benefits as a percentage of pay for each year of service. The pay considered is updated throughout the employee's career to reflect increases in salary.
A typical formula of this type is
1% * FAP5 * service, where FAP5 is the average of the final five years of pay.
Under this formula, an employee who works for 30 years will retire with a benefit equal to 30% of his final average earnings.
Career Average Pay Plan In a career average pay arrangement, employees accrue benefits as a percentage of each year's pay for each year of service. The main difference from the final average pay plans is that the earnings used to determine the benefit are the earnings throughout the entire career, not just the final few years.
A typical formula of this type is
1.5% * annual pay
This benefit will accrue each year and can typically be tracked as either a balance that is annuitized at retirement or as an accrued benefit.
Dollars Times Service Plan This is one of the simpler designs to understand. For each year of service, the employee earns a flat amount, say $300. An employee who works 20 years will retiree with a benefit of $6,000 per year ($300 * 20).
Cash Balance Plan A cash balance plan credits a set percentage of an employee's pay (say 4%) each year into a nominal account. This balance grows each year with interest and further pay credits. This plan design is often referred to as a hybrid plan since it is very similar conceptually to a defined contribution plan invested in a guaranteed income investment.
Cash balance plan benefits can be paid out as annuities, although they are often offered to employees as a lump sum. Unlike more traditional pension benefits, the lump sum from a cash balance can be received by the employee at any age.
Flat Dollar Benefit Plan This is the simplest type of defined benefit plan. The benefit from this type of plan is a flat amount, like $5,000 per year. The benefit does not vary based on pay or service once the employee is vested in the benefit.
- * * * *
The defined-benefit plans that many workers in the past relied on for income in retirement are definitely on the wane, being replaced by defined-contribution plans such as 401(k) retirement saving vehicles, which have employees contribute and manage their own retirement investments within a framework set up by their company. Some companies match a portion of what employees set aside in the accounts.
Related Fool Articles
- Retirement Plan Primer
- How to Take Your Pension
- You Can't Rely on Your Pension
- Your Pension's Rocky Road
- Pension Reform and You
Recent Mentions on Fool.com
- Will Baby Boomers Sink the Economy and Your Portfolio?
- Do Government Jobs Still Have the Best Retirement Plans?
- It's Time for Solazyme Management to Come Clean
- Changing Jobs Too Often May Shrink Millennials' Retirement Funds
- 5 Money Problems 20-Somethings Have Difficulty Accepting
- 7 Investing Disasters and How to Prevent Them From Happening to You