What is a Defined Benefit Plan?

This is the most common retirement plan sponsored by employers. In this plan, the employee benefits are defined by their employment tenure, salary record, and age. It is not directly dependent on individual investment returns. The employer is responsible for managing the portfolio and all the investment risks. There are strict rules regarding the withdrawal of this fund.

How a Defined-Benefit Plan Works

This plan is named defined benefit plan because both the employer and the employee know the computing formula for this benefit plan, in advance. The employer sets aside a specific amount of money regularly in a separate tax-deferred account for all the employees qualified to get this benefit. As opposed to the pension funds, here the payment amounts do not depend on investment return. As it is the responsibility of the employer to manage the plans investment and take all the decision, the risk management is also done by them. Whereas, in the case of the pension fund the employer needs to assume the responsibility of poor returns resulting in funding deficit and it is their obligation to compensate the gap. Under the defined benefit plan, on the retirement, the employee receives a specific benefit or payout. There are different payment options attached to this plan. It can be a fixed monthly payment until death, that is called single-life annuity. A plan can also provide qualified joint and survivor annuity which means a specific pay until death and thereafter a specific benefit for the surviving spouse. Working extra years after the age of retire naturally increases the benefit amount as the amount depends on the service tenure and the final salary drawn. This plan is also called defined benefit pension plan and the formula for computing the amount is known as the career average benefit formula, career average formula or career earnings formula.