What Is a Defined Benefit Plan?

Defined Benefit Plan Explained

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A defined benefit plan is a type of employer-sponsored retirement plan in which an employee is guaranteed a certain monthly benefit during retirement. This benefit is based on their years of service with the company and the salary they held during their career. These plans are funded primarily by the employer, unlike other types of retirement plans that are funded primarily by the employee.

Defined benefit plans have become increasingly less common, though many public sector (and some private sector) employees still have access to them. Keep reading to learn how defined benefit plans work, how they compare to other retirement plans, and whether you can take advantage of one.

Definition and Example of Defined Benefit Plan

A defined benefit plan is a type of retirement plan that employers offer their workers, guaranteeing them a fixed retirement income. An employer determines how much benefit each employee is eligible for based on their average salary and their years of employment. Then, the employer contributes to the pension plan on behalf of each eligible employee to ensure the funds are available for them during retirement. Typically, a defined benefit plan promises a predetermined monthly benefit in retirement.

While defined benefit plans were once far more popular, they’re difficult to find in the private sector today. Data from the Bureau of Labor Statistics shows that in 2020, only about 15% of private industry workers have access to a defined benefit plan. That being said, defined benefit plans are still the industry standard for public sector workers. Roughly 94% of state and local government employees had access to a defined benefit plan, according to 2018 data.

The term “defined benefit plan” is sometimes used synonymously with the term “pension plan.” But pension plans can also be defined contribution plans, which offer a different sort of promise to employees than defined benefit plans do.

How Defined Benefit Plans Work

In the case of many retirement plans, employees are promised a certain contribution from their employers as a percentage of their annual salary. But many employers will only contribute if the employee does so first. Additionally, the amount the employee has available during retirement depends on the investment returns of their retirement account.

Defined benefit plans are the opposite. Rather than guaranteeing a certain contribution, these plans guarantee a certain monthly benefit during retirement. Most often, companies use a formula to determine what benefit an employee will receive. For example, a company might promise a certain monthly dollar amount multiplied by the number of years an employer worked with the company.

The company contributes to the pension plan on behalf of its eligible employees and then invests those contributions. But the main feature that makes defined benefit plans stand out among other employer-sponsored retirement plans is that the investment returns don’t affect the benefit an employee receives during retirement. In that sense, the employer takes on all the risks.

The money in defined benefit plans is insured by the Pension Benefit Guaranty Corporation (PBGC), which was founded in 1974 to encourage the use of defined benefit plans. If a pension plan ends and can’t make its promised payments, PBGC insurance will take over making the benefit payments.

There are two other characteristics of defined benefit plans to know about: vesting and distributions.

Vesting

The federal law that governs defined benefit plans requires there to be a vesting schedule, which outlines how long an employee must work for the company before they start earning retirement benefits. The two vesting schedules that a company may choose from are cliff vesting and graduated vesting.

In a cliff vesting schedule, an employee doesn’t have access to the defined benefit plan for a set number of years when they start working. They become fully vested once they reach a certain threshold. In a graduated vesting schedule, the employee becomes partially vested each year until they reach 100% vesting.

According to the IRS, vesting schedules for defined benefit plans may vary from immediate vesting to a schedule that is spread out over seven years. Check with your company to learn what type of vesting schedule it has so you don’t lose out on valuable retirement benefits.

Distributions

Like other retirement plans, defined benefit plan participants must reach a certain age before they can take plan distributions without penalty. Companies can allow their employees to receive benefits as early as 55 as long as they have retired by that time. And starting at age 62, companies can start paying pension benefits to participants who haven’t retired.

Pension plans often give employees the options of different types of distributions. They can typically choose between a lump-sum distribution when they retire or monthly annuity payments throughout retirement. In the case of the lump-sum payment, employees often roll them over into individual retirement accounts (IRAs), where they can then manage the funds themselves.

The distributions an employee takes from a defined benefit plan during retirement will be subject to federal income taxes. Whether you pay state income taxes will depend on where you live, since some states don’t require income taxes on pension plans.

Defined Benefit Plan vs. Defined Contribution Plan

A defined benefit plan is a type of employer-sponsored retirement account available to some employees, but these plans have become less common. It’s more likely that employers will offer a defined contribution plan. In fact, 64% of private industry workers had access to a defined contribution plan in 2020.

The key difference between a defined benefit plan and a defined contribution plan is what is guaranteed to the worker. With a defined benefit plan, the company promises a certain retirement benefit, which the worker receives regardless of the investment returns. As a result, the investment risk falls on the employer.

In the case of a defined contribution plan, however, the employer promises a certain contribution. But the amount that will be available to the employee during retirement depends on the investment returns as well as their own contributions. As a result, the investment risk is on the employee. The most well-known type of defined contribution plan is the 401(k) plan.

Defined Benefit Plan Defined Contribution Plan 
Guaranteed benefit during retirement Guaranteed contribution during employment 
Investment risk is on the employer Investment risk is on the employee 

What It Means for Individual Investors

Defined benefit plans are becoming increasingly less common for private-sector workers. While you may be offered one as an option in the private sector, you’re most likely to be offered this type of plan if you work for a state or local government institution.

But no matter what type of retirement plan your employer offers, you still have the opportunity to invest in your own retirement, often with the help of your employer. Vanguard’s 2021 How America Saves survey indicates that 96% of companies that offer a 401(k) plan also offer employer contributions.

Key Takeaways

  • Defined benefit plans are employer-sponsored retirement plans that guarantee employees a certain benefit during retirement.
  • These plans are most prevalent in public-sector employment—most private-sector workers don’t have access to them.
  • Employers take on the investment risk of a defined benefit plan, though benefits are insured by the Pension Benefit Guaranty Corporation.
  • A defined contribution plan, which is more common than a defined benefit plan, promises employees a certain contribution during employment. Their actual retirement benefit, however, depends on their investment returns.