Defined benefit plans are retirement plans that are largely funded by employers, with payouts based on a set formula that considers employees' salary, age and tenure with the company. Also known as pension plans, they historically were offered to entice workers to stay with one company for years. But as lower-cost defined contribution plans arose, defined benefit plans became much less prevalent.
There's no formula for how benefit plans are set — one may be based on an employee's average salary for his or her career, while another may use a flat dollar benefit like $800 for each year an employee has been with the firm.
Often, however, the formula is more complex. A company might offer a plan that pays 1.5% of an employee's average salary for the past five years of employment for every year at the company. That would mean that an employee who worked at the company for 20 years might receive a payment of 30% of his or her average salary over those years.
While employers generally get tax breaks for contributing to these plans, they have to provide guaranteed payments to beneficiaries, no matter how the underlying investments in a plan perform. With a 401(k) plan, future payments are reliant on unassured investment performance. Benefits in most defined benefit plans are protected, within limitations, by federal insurance provided through the Pension Benefit Guaranty Corporation.
The pluses and minuses
The big advantages of defined benefit plans include:
Employers have a vested interest in designing and maintaining a retirement benefit program that balances the recruiting and retention benefits it generates with the costs incurred by and the financial liability imposed on the employer.
Finally, note that the laws and accounting rules surrounding defined benefit plans are exceptionally complicated, and both companies and covered employees should get professional advice regarding them.
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