A defined benefit plan is a retirement plan in which employers provide guaranteed retirement benefits to employees based on a set formula. Defined benefit plans, often referred to as pension plans, have become less and less common over the last 40 years. In 1980, 38% of Americans participated in defined benefit pension plans. By 2008, that figure was cut almost in half, falling to 20% of Americans, and the number continues to fall. This decline is especially pronounced in the private sector, where more and more employers have shifted to defined contribution plans like 401(k)s.
There are still employers offering defined benefit plans, though, mostly in the public sector. Here are the basics of how these plans work and how they compare to defined contribution plans.
Defined Benefit Plans: A Definition
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. That’s what 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.
Defined Benefit Plan vs. Defined Contribution Plan
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 is in the name: In a defined contribution plan, it’s only the employee’s contribution (and the employer’s matching contribution) that is defined. The income they receive in retirement – the benefit – depends on how the employee invests, how the market performs, and the rate at which the employee chooses to withdraw their balance.
Frozen Defined Benefit Plans
Many of the remaining defined benefit plans have been “frozen.” This means the company wants to phase out its retirement plan, but will wait to do so until the people already enrolled have aged out of it. In a “soft freeze,” no new employees can join the plan, but workers already participating in the plan continue to accrue benefits. In a “hard freeze,” a company closes the plan to new employees and freezes benefit accrual, too. For those lucky enough to have a job with a defined benefit plan, the risk of a freeze means that having a back-up plan is a good idea.
Why Defined Benefits?
At this point, you may be wondering: Why on earth would any company offer a defined benefit plan? Decades ago, a company could reasonably expect many of its workers to stick around for the duration of their careers; a pension that increased in value the longer you stay with the company helped to keep employees put. Plus, the 401(k) plan only became possible by the Revenue Act of 1978, and it didn’t catch on until several years after that. Between their defined benefit plans and their Social Security benefits, workers could expect to sail into a dignified retirement.
These days, companies have a much cheaper alternative in the 401(k) plan. So, having a generous 401(k) with a high employer match is the new gold standard. Moreover, more and more workers are hopping from job to job every few years rather than stick it out with one or two employers. This has also led to the shift in responsibility from employers to employees.
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. Here’s how it works: If you’re self-employed or have outside income from a solo venture, you can set up your own pension 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 it off.
The problem with making your own defined benefit plan is that you have to meet the annual minimum contribution floor each year – or you’re in violation of IRS rules. Because the benefits of a defined benefit plan are, well, defined, you have to keep funding the plan to make sure it will pay those benefits in your retirement. Plus, you’ll have 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 write off), and who don’t mind losing a little flexibility in the process.
If you’re fortunate enough to have a defined benefit plan through your employer, congratulations! But we still recommend that you save on the side, in a traditional IRA, for example. Why? Because the promise of a pension isn’t as iron-clad as it once was. When it comes to saving for retirement, more is better.
Tips for Achieving Your Retirement Dreams
- 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.
- To maximize your retirement savings, consider working with a financial advisor. Finding the right financial advisor that fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in 5 minutes. If you’re ready to be matched with local advisors that will help you achieve your financial goals, get started now.
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