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A defined benefit plan is one set up to provide a predetermined retirement benefit to employees or their beneficiaries, either as a certain dollar amount each month, or a percentage of compensation.
Employer contributions to a defined benefit plan are very complex to determine and require the work of an actuary. The assets of the plan are held in a pool, rather than individual accounts for each employee, and as a result, the employees have no voice in investment decisions. Once the plan is established, the employer must continue to fund it, even if the company has no profits in a given year. Since the employer makes a specific promise to pay a certain sum in the future, it is the employer who assumes the risk of fluctuations in the value of the investment pool.
There are three basic types of defined benefit plans:
- Flat benefit plan — all participants receive a flat dollar amount as long as a predetermined minimum years requirement has been met.
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Example
A plan might pay 20 percent of average compensation for the last five years, or $500 per month, to each retiree with at least 10 years of service.
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- Unit benefit plan — provides a benefit that is either a percentage of compensation or a fixed dollar amount multiplied by the number of qualifying years of service.
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Example
A plan might provide a benefit of 2 percent of the average compensation of the employee's five highest consecutive years, or a $20 monthly retirement benefit, for each year of service.
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- Variable benefit plan — benefits are based on allocating units, rather than dollars, to the contributions to the plan. At retirement, the value of the units allocated to the retiring employee would be the proportionate value of all units in the fund.
The maximum annual contribution you can make in 2007 to a defined benefit plan is one that would be projected to yield a benefit equal to the lesser of $180,000 ($185,000 in 2008) or 100 percent of the participant's average compensation for the three highest consecutive years.
Very few defined benefit plans provide for the benefits to be adjusted each year to reflect the effects of inflation (called the Cost of Living Adjustment, or COLA), so over the years of your retirement, the value or purchasing power of your benefits may shrink considerably.
The Pension Benefit Guarantee Corporation (PBGC). With a defined benefit plan the employer is legally required to make sure there is enough money in the plan to pay the guaranteed benefits. If the company fails to meet its obligation, the federal government steps in. Defined benefit plans are the only type of pension insured by the PBGC. The insurance works similarly to the federal deposit insurance that backs up your bank accounts. If your plan is covered and the sponsoring company goes bust, PBGC will take over benefit payments up to a maximum amount. The insurance protection helps make your pension more secure, but it is not a full guarantee that you will get what you expected.
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