Defined Benefit Plan

Under a defined benefit plan, the employer promises to pay each employee a specified monthly benefit at retirement. The amount of pension is generally determined based on a benefit formula that is dependent on the employee’s length of service and salary history. The employer is responsible for funding the plan to pay the retirement benefits regardless of profits and earnings. The employer is also responsible for investing the assets and bears the investment risk.

A defined benefit plan is considerably more complicated than a defined contribution plan. The funding process involves the determination of the employee’s “present value” of the promise to pay his or her retirement benefits payable at some future date. As a result of this calculation, an actuary is needed to determine the annual contribution requirement to fund future benefits. In determining the annual contribution, the actuary takes into account anticipated future investment returns and employee’s life expectancy at retirement. In a defined benefit plan, the employee can elect to receive the benefits in the form of monthly benefit or as a lump sum payout.

In determining annual contributions, the maximum compensation that is taken into account is $275,000 (for 2018). The maximum annual retirement benefit is the highest consecutive three-year average compensation or $220,000 (for 2018), whichever is less. These limits are adjusted each year to reflect changes in the cost of living index.

There are different types of defined benefit plans.

The most popular are:

Defined benefit plans are generally established for employers that want larger deductible contributions. The advantage is that contributions for older employees are significantly higher in a defined benefit plan than in a defined contribution plan.