Defined Benefit Plan

A Defined Benefit Plan (DBP) is an employer-funded pension scheme set up to pay a pre-established amount on retirement to employees. Under this arrangement, a company takes full responsibility for planning its employees' retirement fund. This plan offers the twin advantage of greater tax deductions to the sponsor company and a guaranteed retirement income to its employees.

DBP is a formula-based pension plan. The retirement income is pre-defined by a formula based on the employee’s retirement age, compensation history, and duration of service. The employee may choose a fixed income for every month for as long as the employee lives post-retirement or may retire with a hefty amount provided all at once.

• Defined Benefit Plans (DBP) are company-sponsored retirement plans for employees where the retirement benefits are known beforehand and derived from a set formula based on specific criteria.
• The formula is usually based on an employee’s salary, tenure of service, and retirement age.
• 401(K) is the most common retirement plan in the U.S. It is a Defined Contribution Plan and is different from the DBP.
• Pensions and Cash Balance are the two common types of DBP.
• To be entitled to a company's defined benefit plan, an employee must serve the company for a stipulated term, called the vesting period.

DBP is a traditional pension vehicle for employees primarily sponsored by employers. The crucial element of this scheme is that the employers take the onus of saving for employees’ retirement on their behalf. Federal insurance usually secures this plan through the Pension Benefit Guaranty Corporation.

Under this approach, the pension benefits at retirement are calculated well in advance using a formula based on employees’ years of service, age, and salary. This computation enables the employees to have an estimate of the income they are likely to receive on retirement beforehand.

To reserve funds for making pension payments to its retired employees, the employer contributes to a fund earmarked for it. Contributions are invested to generate returns. The company typically hires a third party to look after the investment strategies of the fund. The returns from these investments are used to guarantee a fixed monthly income to the employees at the end of their working life. The employees may also opt to receive a lump sum at retirement.

Note that the company bears all risk of non-performance of invested contributions, thus using its earnings to compensate in case of any funding deficit. In other words, the employee must receive the stipulated amount irrespective of the cost to the company.

However, to be eligible for a DBP, an employee must serve a company for a particular time or years. It is referred to as vesting. Only a vested employee is entitled to retirement income under this plan. However, if an employee leaves the company before completing the vested years, the employee cannot claim any benefits under the scheme.

This pension plan is advantageous for both employees as well as employers. Employees benefit from assured retirement income without facing any investment risks, while employers get liberal tax rebates. However, setting up and maintaining this plan is costly and complicated.

Over the years, the paradigm shift in the tax laws and DBP's complexity paved the way for the emergence of an alternative pension scheme called the Defined Contribution Plan. Consequently, most modern corporates and private sector firms replaced DBP with Defined Contribution Plans.

Defined Benefit Plan vs Defined Contribution Plan

The main difference between a DBP and a Defined Contribution Plan lies in who bears the burden of contributing to retirement funds. In the former, it is undertaken by the employer, while in the latter, the employee and employer both contribute to the employee’s retirement account.

Moreover, in the Defined Contribution Plan, employees endure the investment risks associated with the pension funds. Therefore, unlike DBP, the retirement income is not fixed. The most common and popular Defined Contribution Plans are 401(K) and 403(B) plans.

As per a CNBC article on pension finance, companies have been phasing out of DBP in favor of the Defined Contribution Plan over the past two decades.

The DBPs are classified into two types, which are:

#1 - Pensions

Pensions are a fixed amount employees receive every month after their retirement. They are calculated based on a formula that considers their served period and compensation. Sometimes age is also considered a factor.

The employee receives the pension as periodical payments or commuted value at retirement. Note that an employee becomes eligible for a Defined Benefit Pension Plan only after serving for a certain period.

#2 - Cash Balance Plans

The Cash Balance Plans allow employees to set up a retirement account to claim when they leave the company. The cash balance in the retirement account is maintained by contributions from the employer (a percentage of employee’s pay) and interest on such contributions. This way, the retirement account balance will have a pre-defined amount at retirement. Here also, the investment risks are borne by the employer.

Every year, the employer will assess the account, and at the time of retirement, the cash balance in the account is received by the employee in the form of an annuity (fixed monthly payout) or one-time payment. An employee can choose either of the payment options.

Judy and Jennifer are both neighbors. They both started their jobs on the same day in two different companies. They worked hard and climbed the corporate ladder with perks, promotions, incentives, and salary hikes. Both Judy and Jennifer worked for their respective companies for 35 years and retired.

Judy's company provided the traditional defined pension plan, wherein the company contributed to a retirement fund that would be used to finance Judy's pension. Her retirement income was computed using a formula based on her age, salary, and service tenure.

Judy opted to receive it in the form of a pension, enjoying a fixed amount every month. She knew beforehand the amount she would receive at retirement and planned her retirement life accordingly.  

On the other hand, Jennifer’s company employed the cash balance plan. The company created a notional retirement account in which it put a portion of her pay and the interest earned from it. Finally, Jennifer received the total cash balance in her account, accumulated over the years, on her retirement.

She cashed the account on retirement, withdrawing a lump sum amount of money at once. She reinvested her retirement income effectively and reaped benefits from it for the remainder of her life.

DBP helped Judy and Jennifer secure their old age without bearing any risk. All saving and investment risks were assumed by their employers. They both made their individual choice on how to receive the amount and enjoyed their retirement fund.

As per a report in Reuters earlier this year, OMERS, the most popular DBP Pension in Canada, reported their first annual loss after the financial crisis. They have blamed the COVID 19 pandemic for it. The pandemic adversely impacted the economy, reducing the returns on OMERS' investment portfolios, which averaged at 11.2% until 2019.

This has been a Guide to Defined Benefit Plan and its definition. Here we discuss how Defined Benefit Plan works and its types, examples, and a comparison with defined contribution plans. You may learn more about financing from the following articles –

• Pension Fund
• Keogh Plan
• 401k Plan