Defined Benefit Plans

Defined-benefit plans used to be the gold standard retirement plan for employees in both the private and public sectors. Employees were generally not required to contribute any money to the plan but were guaranteed a set payment – a defined benefit – once they retired. Today, however, defined-benefit plans are limited to only very large corporations and public sector employees. And, most who participate in a defined-benefit plan today are required to contribute at lease a small amount of their salaries. While most private corporations have shifted away from defined-benefit plans to defined-contribution plans, almost all public employees – federal and state government workers, teachers, police officers – continue to have access to defined-benefit plans.

A defined-benefit plan establishes a set payment amount for a retired worker based on the number of years of service, the highest employment grade achieved, and other factors as defined by the employer. In the case of public sector workers, a contract usually defines the amount of the payments and how they are earned. In most cases, the employee contributes to the plan via payroll deductions. Even though the employee makes contributions to his or her plan, it's still a great deal because regardless of market conditions, amount contributed, or the number of years he or she lives following retirement, the employer is obligated to continue making payments.

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Who is Eligible to Participate in a Defined-Benefit Plan?

While it may not seem fair, federal law allows employers to cover certain employees under a defined-benefit plan but not others. An employer could, for example, provide one plan for salaried workers and a separate plan for hourly employees or those who belong to a union. Part-time employees are typically only eligible if they work at least 1,000 hours annually, or roughly 20 hours each week.

Most defined-benefit plans require a participant be at least 21 years of age and have at least one year of service to be eligible. Employers have the option of making exceptions to these rules provided all employees have access to the same exceptions. For example, if the plan is established several years after incorporation, the employer may choose to include all employees at the inception of the program, even if they haven't completed one year of service.

Questions to Ask about Your Defined-Benefit Plan

If you're fortunate enough to participate in a defined-benefit plan, you'll want to make sure you ask questions about the company that manages the investments, the amount of the benefit you'll be paid at retirement, the types of retirement benefits that are paid, whether or not benefits are guaranteed, and what happens to your benefits if you leave the company before you reach retirement age.

Most defined-benefit programs have two entities that control and manage the investments. The employer is responsible for making sure that enough money is contributed to the plan and that the contributions earn enough to cover all future obligations. The plan administrator is responsible for making sure the funds are properly managed and that they are earning enough to cover the employer's future obligations. It's important to remember that employees who contribute to a defined-benefit plan don't actually own the money they are contributing. Rather, the money from all contributors is pooled together and paid out to those who are eligible for benefits.

The amount of the benefit that is paid upon retirement is based on a formula. If your benefit is based on the number of years of service and the highest salary achieved, you'll want to make sure that you complete the minimum number of years in order to obtain the maximum benefit. Leaving the company a year too soon can have a devastating impact on the amount of the benefit that is paid upon retirement. The type of benefit may or may not include options such as a cost of living adjustment each year. If the rate of inflation is 3% each year, but your benefit amount does not increase, you may need to supplement your income by drawing on your savings, individual retirement account, or other source of income. Finally, ask if your benefits are guaranteed. The Pension Benefit Guaranty Corporation (PBGC) guarantees only a certain amount of benefits.

What is the Pension Benefit Guaranty Corporation?

The Pension Benefit Guaranty Corporation (PBGC) was created as part of the 1974 Employee Retirement Income Security Act (ERISA) in order to protect the pension benefits of retired and still-working employees of companies that offer pensions. The PBGC guarantees certain basic benefits, such as the receipt of employer paid pension benefits for workers who have not yet retired, survivor benefits for the beneficiaries of deceased pensioners, disability benefits, and most of the benefits provided to employees who take early retirement.

The PBGC does not guarantee benefits that are part of a severance package, vacation pay for unused vacation days, disability payments for workers who become disabled after a bankruptcy starts or the termination of the plan, and lump-sum death benefit payments for deaths that occur after the termination of the plan. For these reasons, it is imperative that employees of financially troubled companies fully understand how their benefits will be impacted in the event of bankruptcy or corporate dissolution.

What are the Advantages of Defined-Benefit Plans?

The employer manages a defined-benefit plan and can invest the money in the way that it and the plan administrator see fit. The risk of not having enough money to satisfy payout obligations rests solely with the employer, which means the employee does not have to make any decisions about how to invest his or her contributions. Therefore, all future risk resides with the employer to make the payments.

What are the Downsides of Defined-Benefit Plans?

One of the biggest mistakes participants in defined-benefit plans make is not allowing for risk. While market, credit, and investment-decision risk reside with the employer, the employee also assumes risk. For example, private corporations can dissolve their defined-benefit programs at any time they choose. Under certain circumstances, they can also reduce the amount of the benefit that is paid to a retiree.

If you participate in a defined-benefit plan, it's always wise to protect yourself by establishing individual or Roth retirement accounts and saving additional money for retirement in savings, money market, and brokerage accounts. While it's great to have a guaranteed benefit, there's always the possibility that the benefit could be reduced or even taken away completely.

While we've covered the basics of pensions here, there is much more to developing a solid retirement plan. To make sure you're on the right track, contact a licensed financial advisor. It only takes a few minutes, Start Now.

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