What Is a Defined Benefit Pension Plan?

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When it comes to funding your retirement, you have many different investment vehicles. One of the most popular employer-sponsored plans is the defined benefit pension plan. While this plan has been around for many many years, it is not a plan that many workers are familiar with. So what exactly is a defined benefit pension plan?

Definition

A defined benefit pension plan is a retirement plan that is sponsored by your employer. In a defined benefit pension plan, the benefits available to you upon retirement are calculated using a formula. This formula is normally based on a number of factors, such as your average salary before retirement, length of service and age at retirement. Unlike a 401(k), it is not necessary for employees to make contributions to this type of pension plan for them to reap the benefits at retirement. In a defined pension plan, the company is responsible for making contributions to your plan.

Investment Decisions

Employees are free from having to make investment decisions with the defined benefit pension plan. This lowers the risk for participants because the average worker simply does not have the time to do the research that is necessary to make an informed investment decision. Because the company makes all of the investment decisions, they assume the investment risk. If the market turns negative, the loss is shared by all participants.

Payments

Payments from a defined benefit pension plan can be issued to employees at retirement in one of two ways. The employee can either receive a lump sum for the entire amount, or he can receive monthly payments until his death. In certain plans, surviving spouses or beneficiaries will continue to receive payments. However, if this is the case, the payment amount is typically reduced.

Defined Benefit Pension Plan Structure

Defined benefit pension plans can be set up by a company in three different structures: flat, unit and variable. The flat plan requires that the company pay the plan's participants a fixed dollar amount as long as they have worked for the company for a minimum number of years. In a unit plan, the amount of the payment is calculated by multiplying the years of service by a percentage of your compensation. So the benefit could be 5 percent of compensation multiplied by the number of years. In this case, if the worker was with the company for 20 or more years she would receive a full salary. In the variable plan, the company invests in a unit structure. The employee earns a specified number of units for each year of service.

Warning

Do not rely solely on your pension plan for retirement planning. Companies have had problems with pension plans over the years as the number of people drawing from the plan increases. An example of this is the union pension plans for the auto manufacturing industry. Pension plans are a valuable benefit; they are ultimately free money from your company at retirement. However, you should speak with a retirement specialist who can help you plan for your future.

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