What is a Defined Benefit Plan? (US Pension)
Defined Benefit Plan is an Employer-sponsored retirement plan where employee benefits are computed using a formula. The formula may differ from company to company. However, generally, it includes employment tenure and salary. The important part in defining the benefit plan is you would know what amount of funds would be deducted toward pension reserve and how much pension per month you would get on retirement.
Suppose you are 25 years of age, freshly graduated with an annual salary of $ 60,000. Your employer supports the Defined Benefit plan and you are informed that every month $500 would be deducted from your salary multiplied by years in service. Assuming you would retire on turn 60. Hence this leads to a working tenue for 35 years. Therefore, when you retire you would get a monthly pension of $ 17,500 (35*500) till your death. It is also important for you to understand, that every year you would save $ 6,000 for 35 years in your pension account which adds up to a corpus of $ 210,000. You would surely earn interest on your savings. These saving i.e Pension funds are managed by professional people and highly regulated. Hence this gives you a surety that your pension income is guaranteed.
Upon reaching retirement, you have 2 options to select from,
- To opt for monthly income till you die, called annuity payments
- To get the investment amount on lump-sum bases which would lead you to manage your funds till you retire.
Defined Contribution Plan
Defined Contribution Plan is a plan in which equally funds or percentage of income is contributed by employee and employer.
Let’s understand the topic by knowing the human life cycle.
The picture symbolizes 5 phases of life from Baby to Teen to Old age. Our motive is to earn money and live a happy life fulfilling our goals. Most US citizens start working on attaining Teen-age. After university degree, an average America starts with full-time employment with an average salary of $ 56,000 Per year. As of April 2019, the US employed 129.21 Million1 people. You would wonder, why I am explaining this because our working ability decreases as age increases. Leading to which income reduces with only increase in expense.
There would be a time when we would be replaced by someone else and that age is retirement. Mostly, the retirement phase is when we are financially depended on our family, children or government. Hence, to avoid such dependency, we have a concept of saving which is called Pension. From the day you receive your social security number and take up employment, some portion of your income would be deducted and deposited with a pension house/pension fund company. You would get savings (pension) under two scenario,
- On reaching your retirement age – Generally, the retirement age in the US is 60.
- Death or permanent disability to work
Points to Remember – Defined benefit plans (DBP) are better and mostly preferred for workers and employers because of the plan is considered more secure in comparison to the Define contribution plan (DCP) as its pensions can be easily predicted and it cost employers less to what DCP costs.
Advantages of the Defined Benefit Plans
let’s look at how much an employee would be benefits and employers would be benefited because everyone has 1 ultimate goal, to reduce cost and maximize returns. Hence for the employee, its maximum returns whereas for employers its minimum cost.
Advantages for Employees
- The employee would know its retirement amount in advance (from the day it signs the DBP contact).
- Benefits are indifferent to stock market risk/fluctuations or increase/decrease in bond yield.
- Comparing with DCP, the Defined Benefit Plan generates a higher return on investments which would include premature/ accidental death benefits to family members.
- Due to the stable and risk-free nature of the Defined Benefit Plan, it leads to a higher workforce in the organization. This promotes loyalty and helps to retain valued staff
- As these funds are a collective investment and professionally managed, the savings generate higher returns with relatively less expense (cost of hiring portfolio manager, administration charges, etc).
Disadvantages of Defined Benefit Plans
- Employees would not have control over funds, i.e they would not know where their funds are invested as an investment decision and handling is done by experts.
- Employees exactly know how much they would get on retirement, they do not have the option to increase their retirement benefit.
As soon as you get your social security number and take up employment, start contributing towards your pension i.e retirement planning. Due to the enactment of the Employee Retirement Income Security Act (ERISA) in 1974, Defined benefits plans are guaranteed with insurance under a program which is administered by a government agency called the Pension Benefit Guaranty Corporation (PBGC).
As per our research, we have observed that Defined Benefit Plans are more cost-effective for all stakeholders i.e government, taxpayers and have a proven record in meeting the retirement needs of the employees. The plan is cost-effective because it averages risk over a large number of participants instead of reducing it by higher contribution as necessary in DCP. Historically, the Defined Benefit Plan has generated higher returns on its investment with lower fund management fees.
In simple terms, of 1 dollar paid in pension to the pensioner, about 65 to 80% comes from its investment returns and not the principal he invested during earning age. I.e of $ 17,500 received on turning 60, he would have contributed just $ 3500 rest is his interest accumulation over 35 years tenure. Due to this, young workers opt to define Benefits plans and prefer to invest with public pension funds instead of privately managed.
As per voting conducted in 2008 in West Virginia which comprised of 79% of teachers who voted to switch from DCP to DBP, in this survey, 70% of the voters were under the age of 40.
This has been a guide to What is a Defined Benefit Plan and its Definition. Here we discuss the Defined Contribution Plan with its Advantages and Disadvantages. You can also go through our other suggested articles to learn more –