A defined benefit plan is a retirement plan in which employers provide guaranteed retirement benefits to employees based on a set formula. These plans, often referred to as pension plans, have become less and less common over the last few decades. This decline is especially pronounced in the private sector, where more and more employers have shifted to defined contribution plans, like a 401(k). There are still employers offering defined benefit plans, though they mostly exist in the public sector.
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Understanding Defined Benefit Plans
In a defined benefit plan, a company takes charge of its workers’ retirement income. Using a formula based on each worker’s salary, age and time with the company, an employer will pay into and manage a retirement plan. In retirement, the workers draw a dependable check from the company plan, regardless of how the market performs, which makes the benefits defined. The company bears the risk of stock market fluctuations, meaning that the worker doesn’t have to worry that a downturn will make retirement unaffordable.
If you’re wondering why a company would do this, decades ago a company could reasonably expect many of its workers to stick around for the duration of their careers. In turn, a pension that increased in value the longer you stay with the company helped to keep employees on.
401(k) plans only became possible in 1978, and they didn’t catch on until several years after that. Between their defined benefit plans and Social Security benefits, workers could expect to sail into a dignified retirement.
These days, companies still with the much cheaper 401(k). Therefore, having a generous 401(k) with a high employer match is the new gold standard for employees. In addition, more and more workers are hopping from job to job every few years rather than staying for the long haul. This has led to the shift in responsibility from employers to employees.
Many of the today’s remaining defined benefit plans have been “frozen.” This means the company is phasing out its retirement plan, though it’s waiting to do so until the enrollees surpass the age requirement. In a “soft freeze,” no new employees can join the plan, but workers already participating in it continue to accrue benefits. In a “hard freeze,” a company closes the plan to new employees and freezes benefit accrual, too.
Pros and Cons of Defined Benefit Plans
Just like any other type of retirement plan, defined benefit plans have their advantages and disadvantages. For starters, they provide employees with an immense amount of financial stability in retirement. That’s because their structure ensures you won’t outlive the pension funds. Payments also come in a specific format, meaning there’s no question how much you’ll receive and when.
Many defined benefit plans also grow with to inflation. As a result, inflation over long periods of time won’t affect your money as much as a defined contribution plan participants. Defined benefit plans also feature low fees, meaning more of your money will stay in your pocket.
Companies that use defined benefit plans choose the investments for the plan. That makes it so employees won’t be able to pick their own investments as they can with most other retirement plans. This can be a major downside, as many people would prefer to have complete control over their retirement funds.
Because defined benefit plans are meant to keep employees at a job for years, they can lack flexibility. Although there are ways to transfer your funds from one job to another, your projected benefits will likely suffer.
Defined Benefit Plans vs. Defined Contribution Plans
The defined benefit plan used to be common, particularly in heavily unionized industries, like the auto industry. Today, though, retirement plans that depend on contributions from employees have largely supplanted them.
These are, appropriately enough, known as “defined contribution plans.” The rules of defined benefit plans usually require worker participation, whereas participation in defined contribution plans is often optional. Some companies offer both defined benefit and defined contribution plans.
The key difference between each of these employer-sponsored retirement plans is in their names. With a defined contribution plan, it’s only the employee’s contributions (and the employer’s matching contributions) that’s defined. The benefits they receive in retirement depend on how the employee invests, how the market performs and the rate at which the employee chooses to withdraw their balance.
On the other hand, defined benefit plans ask the employer to take on the risk, and the employee retirement benefits are specific and predictable. Again, the employee’s salary, time working at the company, age and other factors affect the size of their eventual benefits.
The Solo Defined Benefit Plan
There is a way certain savers can start a DIY defined benefit plan. It builds off of contributions you make yourself, without any help from your employer. So if you’re self-employed or have your own outside income, you can set up your own plan. The contribution limits are generous, and you can deduct your contributions at tax time. It’s also a great way to make catch-up contributions to your retirement savings if you’ve put saving off.
The problem with making your own defined benefit plan is that you have to meet the annual minimum contribution floor. If you don’t, you’ll be in violation of IRS rules. Because the benefits of a defined benefit plan are very specific, you have to keep funding the plan to make sure it will pay those benefits in your retirement. Plus, you’ll need to have an actuary perform an actuarial analysis each year. These “solo defined benefit plans” are good options for people with a lot of income to save, and who don’t mind losing a bit of flexibility in the process.
If you’re fortunate enough to have a defined benefit plan through your employer, learn about its ins and outs. This doesn’t mean that you shouldn’t save elsewhere though, like in a Roth or traditional IRA. That’s because the promise of a pension isn’t as iron-clad as it once was. When it comes to saving for retirement, more is always better.
Tips for Achieving Your Retirement Dreams
- To maximize your retirement savings, consider working with a financial advisor. Finding the right financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors in your area in five minutes. Get started now.
- Don’t forget to factor Social Security into your retirement plans. SmartAsset’s Social Security calculator can help you determine what kind of monthly benefit you can expect.
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