A defined benefit (DB) pension plan is a fund that is designed to provide a guaranteed income to employees in retirement. Similar to defined contribution plans like 401(k), 403(b) and profit-sharing plans, which have become more common, pensions are offered through an employer. In contrast to defined contribution plans, a pension plan guarantees retirement income.
Types of Defined Benefit (DB) Pensions
Defined benefit pension plans can be separated into two sub-categories:
- A standard defined benefit pension, or
- A cash balance defined benefit pension.
The differences between the two types are the vesting schedule and the lump sum payout option.
Cash balance defined benefit pension plans are offered by some employers because it provides a guaranteed retirement benefit based on its stated account balance. Plan benefits are defined in the plan documents and investment results do not impact plan benefits.
Example: An you have an account balance of $100,000 at age 65, you would be entitled to a guaranteed monthly payment based on the account balance. The annual payment might be $8,500 for life (paid as an annuity). Instead of the annuity, there's an option to receive the funds as a lump sum (with spousal consent). This distribution could be retained or rolled over into an IRA.
Pension accounts are vested based on the plan, but plans follow one of two vesting schedules:
- A one-to five-year cliff vesting, or
- A seven-year graded vesting schedule (fully vested in year seven)
When account values are vested, the account is owned in full allowing for it to be carried forward if or when an employee leaves the company. Any amounts not vested reverts to the employer when the employee leaves.
Calculating the Value of a Pension
Pension plans have a formula to determine the amount of benefit an employee will receive in retirement. The standard equation is years in plan x final salary x plan benefit % = total benefit.
The formula is made up of four parts:
- The years in plan (the number of years an employee participates)
- The final salary (the final average compensation)
- The plan's benefit percentage (established by the employer and applied to the first two items)
- The total benefit (the full value of the pension to be paid to the employee in retirement)
Example: if an employee has participated in the employer’s pension plan for 35 years, with a final average annual salary of $70,000 and the plan benefit percentage is 2.5% -- then the annual retirement benefit will be determined as 35 x $70,000 x 2.5% = $61,250.
Pensions and Social Security
Some pension plans may limit or eliminate a participant’s ability to receive Social Security benefits. Employees in some federal, state, education, railroad retirement and other organizations may not receive retirement benefits from Social Security due to plan structure. If this impacts a worker, payments have not been made into the Social Security system. Instead, payments have been made into the employee’s pension plan. The two most common provisions that may impact potential Social Security retirement benefits are the Windfall Elimination Provision and the Government Pension Offset. Employees who believe they may be affected by a provision should contact the Social Security Administration online or call 1-800-772-1213 or the TTY number 1-800-325-0778.
Pension plans are required by the Employee Retirement Income Security Act (ERISA) to provide a benefit to spouses of deceased participants. Because the surviving spouse’s benefit is required by ERISA, any changes must be approved in writing by the beneficiary spouse prior to the participant’s death. This rule was created to protect spouses from losing an ongoing retirement benefit without knowledge of the change. This benefit may be equal to 100% of the plan participant’s benefit but commonly is a percentage of the original benefit, such as 75% or 50%.
Example: if a plan participant receives a monthly benefit of $1,000 the surviving spouse would receive a monthly benefit of $500.
These pension plans are “qualified,” which means they abide by the Employee Retirement Income Security Act (ERISA) rules. Employers must provide regular reports to participants about their accounts and cannot discriminate in favor of one employee over another. Employees are eligible to participate in a plan when they reach age 21 and have one year of service at the company.
Employers who encounter financial challenges may declare bankruptcy, terminate the plan, underfund or stop funding the plan altogether. If any of these circumstances occur, the participants are at risk of not receiving the plan benefits – but the ERISA rules make it less likely to happen due to the establishment of the Pension Benefit Guarantee Corporation (PBGC). Plans covered by the PBGC guarantee benefits will be paid to the employees if the employer’s plan becomes unstable or is terminated. The benefit may not be the same as the original benefit, but it can be substantial. PBGC benefits also extend to a surviving spouse if that option is chosen.