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Submitted by: Chris Tomkins
A defined benefit plan is one of the two commonly available retirement options offered by employers to help their employees plan for the future. Under this type of a plan, the company specifies what benefits will be received by the employee upon his or her retirement, based on the years of service provided to the company. This type of plan is most commonly referred to as a pension; it was once the only option, before the passage of 401(k) opened the door to defined contribution plans. Under a defined contribution plan, the company specifies what contribution it will make to an employees retirement plan, but the results are not guaranteed upon retirement, the employee receives whatever has been amassed to date. Defined contribution plans often involve a matching feature by employers the employee decides what dollar amount or percentage of his or her pay will be contributed to the plan and the employer matches it on some basis. Matching may be on a one-for-one basis or some lesser match. Outside of unionized groups of employees, defined contribution plans have become more common than defined benefit plans.
The advantage of a defined benefit plan is that it encourages loyalty to a single employer over time the longer one works for a single employer, the higher the benefit amount that is accrued. Under this approach, a company will define what amount will be received by an employee upon retirement based on an agreed upon formula. This amount is usually calculated as a percentage of the employee’s salary at retirement. The more years of service provided by the employee to the company, the greater the percentage of their pay at retirement that will be received. There is often a vesting period as well, before which a reduced or no benefit will be received; in some cases, a pension will be received by the employee at retirement age, even if that employee has left and worked elsewhere. The benefit is paid in most cases for either a set number of years, or, more commonly, until the death of the employee.
Planning to provide for the retirement benefits of their employees is a significant challenge for a company. Typically, a company will put aside an amount of money each year that the employee is employed in the hope that it will grow sufficiently to cover the benefit in the future. The employer tries to project the growth in the pay of the employee, the number of years that will be worked, the number of years that the benefit will be paid, and the level of return that must be achieved on the reserved capital to meet the future pension burden. Based on various factors, a company’s pension plan is said to be overfunded or underfunded, depending on how much capital is in the plan relative to the above projections. Making these types of estimates is an entire area of accounting and is subject to specific rules that are designed to maintain the long-term financial health of a company while still protecting the future benefit to be received by current and future employees.
One of the biggest concerns during major market shocks is that pension plans tend to be adversely affected and are forced to re-evaluate their position. Risk management in this area has become increasingly important, particularly as the baby-boomers move closer to retirement and the number of people expected to be collecting pension benefits is expected to spike. In light of the recent market shocks, companies are re-assessing their projections and trying to make the adjustments needed to be well positioned for their future cash needs.
There has been a long-term struggle between defined benefit and defined contribution plans, and which was preferred by employees. In most cases, a defined benefit plan is preferred because it allows one to easily to plan for life after retirement. Because you know what your income will be after you stop working, you are able to plan. The arguments against this include control and expense. Certain proponents of defined contribution plans have asserted that an employee should have a say over how his or her money is managed. The better argument against defined benefit plans is that they are very expensive for a company and are not as efficient when workforces ebb and flow. When coupled with the power of collective bargaining, a pension plan can become a significant operating expense for a company and divert its attention from its core business. In either case, defined benefit plans can be quite favorable for all involved if their risks are carefully managed.
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Defined Benefit Pension Plans
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