What Is a Defined Benefit Plan? (Types, Benefits, and Options)
By Indeed Editorial Team
Published April 25, 2022
The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.
Benefit plans are financial aids designed to benefit employees in an organization by ensuring that employees continue to receive financial payments upon retirement. Many organizations have different types of benefit plans which employees can select. Understanding the different types of defined benefit plans can help you make an informed decision in choosing an employer with suitable benefits for you. In this article, we answer "What is a defined benefit plan?", identify its types, examine its benefits, and highlight the benefit plan options you can select.
What is a defined benefit plan?
A defined benefit plan is a retirement program established by employers for the benefit of employees by using a formula that considers many factors, such as salary length. It guarantees a calculated benefit for qualified employees upon retirement. The employer often manages the retirement plan, including all related investment risks. They usually handle this by employing an investment manager to oversee such functions. An employee can't withdraw these funds without satisfying certain requirements.
Defined benefit schemes typically differ from other retirement plans because employers use a general formula to determine each employee's entitlements ahead of time. In certain cases, employers may not have enough money to finance the defined benefit scheme due to poor investment decisions or returns. The employer usually supplements the existing funds with cash contributions to remedy the situation.
Types of defined benefit programs
Here are the two major types of defined benefit programs:
Pension plans are the most common types of defined benefit schemes. They're usually in the form of monthly payments to retired employees. Pension plans can be a great incentive to encourage intending employees to pursue a job in a company. This is because of the long-term stability the plan offers, usually lasting till the beneficiary's death. Government institutions most commonly use pension plans. The terms and conditions of a pension plan usually vary according to the employer. For example, some employers require employees to work with them for a certain period before becoming entitled to a pension plan.
Employees can also influence the terms of their pension plan. For example, some employees may specify a preferred payout method. Once employees satisfy all relevant terms, they're entitled to receive a pension payment upon retirement.
Cash balance plan
A cash balance plan involves the employer paying the balance of the employee's pension when the employee leaves the company. This type is different from a pension plan because the employer makes a one-off payment. Under the cash balance plan, the employer usually creates an individual account for each employee containing a specific lump sum. The employer can determine this lump sum by calculating a specified percentage of the employee's annual salary.
Upon the employee's retirement, the employer pays them the lump sum, including any interest that may have accrued due to investments. In this case, the employer often manages all investment decisions and risks. Lastly, while the payment comes as a lump sum, the total sum of a cash balance payout may be lower than a pension plan payout.
Advantages of a defined benefit plan
Here's an outline of the various advantages of a defined benefit program:
Minimum employee involvement
The burden of establishing the rules and policies guiding a defined benefit program usually depends on the employer. When establishing these plans, employers often have existing rules governing pensions or cash balance plans. As a result, employers typically determine the percentage of the employee's salary that goes towards the plan, the appropriate retirement age, and the payout options available to employees. Handling these details can help relieve stress for the employees, as they don't require to research or make these decisions alone. Additionally, it improves their financial well-being by reducing the risk of individuals signing up for unprofitable pension plans.
Defined benefit programs are some of the most useful benefit plans because they offer higher payouts to employees over time than other benefit plans. In other benefit plans, the amount determined by the employees may be too small to maintain an adequate standard of living post-retirement. Defined payment programs can avoid this issue and guarantee a higher payment because the employers consider several key factors while setting them up. In addition, due to its long-term duration and stability, employees usually prefer defined benefit programs.
One major advantage of defined benefit programs is that governments usually regulate them at all levels. These government agencies are responsible for insuring the pension plan up to a specific amount. This usually secures employee pensions to a large extent regardless of unforeseen circumstances. For instance, if a company declares bankruptcy, the government often makes the insurance payments, ensuring that retirees still receive their entitlements. Having an insured retirement plan can also protect employees from economic hardship and protects employers from incurring legal liability.
Related: What Is a Contract Employee?
Another advantage of defined benefit programs is that the employees can easily calculate and estimate their payouts. This is because employers base the payout and establish rules, terms, and conditions. This can give retirees the ability to plan their retirement on a payment structure, determining when and how employers disburse their entitlements.
Being able to predict their payout usually encourages stability and financial planning for retirees. This can also ensure they make smart financial and investment decisions because they can estimate their income. More importantly, employees can easily hold employers accountable when they know what to expect, leading to greater transparency.
The employers are typically responsible for supplying the payout of their employees under each defined benefit program. As a result, employers often provide a large amount of funds which helps to increase the money placed in a retirement fund. In a defined benefit program, the employer always invests the money, and they're also obligated to make extra payments to make up the difference if the investments perform below expectations.
This distinguishes defined benefit programs from other types of plans. In other cases, the employee incurs the risk if the investment goes bad, which can eventually lead to a reduced payout. The fact that the employer incurs the risk of the investment and the employee eventually receives payout makes defined benefit programs more profitable and convenient for employees.
Defined benefit programs usually come with various payment options, allowing retired employees to determine how they want to use their entitlements. For example, a retiree may split their pension between themselves and a few beneficiaries. This level of flexibility allows retired employees greater control over their finances, which can lead to a better quality of life. Additionally, it protects the retired dependents who may need the money for sustenance and other expenses.
Defined benefit program payment options
While employers determine the terms and conditions of a defined benefit program, employees can usually decide the payment option they prefer. Here's an outline of some defined benefit program payment options:
A single-life payment plan is a benefit plan in which money is paid out to retirees in installments until their death. Usually, these payments are monthly, but the retiree can choose another payment option they prefer. These installments are often equal in value. Compared to other benefit plans, single-life payments are of a larger value because they conclude upon the recipient's death. This differentiates it from other plans that pay spouses and relatives even after the original recipient's death.
Single-life with term certain
This occurs when a retiree receives regular installments of similar sums for a defined payment term period. This doesn't consider the duration of time the retiree lives after retirement. For instance, if a retiree dies before the end of the payment term, the remaining payment balance goes to a beneficiary, which may be a spouse, child, or next of kin. Still, it's important to note that payments under this plan may diminish over time.
100% joint and survivor
This is a payout method in which an employee chooses to receive reduced monthly installments to increase the length of their payment period and to include the life of another beneficiary. In most cases, the essence of this payment method is to provide a better quality of life to a spouse, child, or loved one in the event of death. Upon retirement, the payment continues for the duration of the life of the retiree and the named beneficiary. The total amount paid remains the same, but the company often divides it to meet the employee's specifications.
50% joint and survivor
This payment method occurs when the listed beneficiary of a retiree is to receive 50% of an original payout upon their death. While in a 100% joint and survivor, the beneficiary receives the same payment as the retiree. In a 50% joint and survivor, the beneficiary typically receives only half of the retiree's payment during their lifetime. This payment option is often useful for retirees who want to provide an extra source of income for their beneficiaries while guaranteeing themselves a reasonable standard of living.
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