Defined Benefit Plans
Unlike defined contribution plans where benefits are based upon performance of contributions, defined benefit plans which promise a certain benefit at retirement (for example,
30% of salary for life). Although the long-term trend is towards defined contribution plans, defined benefit plans will still be around for a while.
With defined benefit plans, the employer usually makes all of the plan's contributions. Years ago it was fairly common to have employees contribute to defined benefits plans, but
now it's rare.
Compare this to a typical 401(k) plan, for example, where you might, as an employee, make the primary contributions while your employer matches some or all of your contributions.
Contribution Limits
With a 401(k) plan, your contributions can't exceed $10,500 (in the year 2001 ). The total of your contributions and employer contributions made on your behalf to a 401(k) plan
(and any other defined contribution plan sponsored by your employer) is limited to the lesser of 25% of your compensation or $35,000.
The defined benefit plan takes a different approach. An employer contribution can be the amount needed to fund a normal retirement benefit, up to the lesser of $135,000 (in the
year 2001 ), or 100% of the average compensation in the three highest years of the employee's tenure.
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Retirement Benefit is Certain
The benefit level in a defined benefit plan is fixed, regardless of how poorly the retirement plan assets may perform in the market. If the rate of return is too low on defined
benefit plan investments, your pension isn't reduced. Instead, your employer is required to make additional contributions to make up the difference.
With a defined contribution plan, there are no guarantees that the size of the pension benefit will relate to your salary. In fact, there is no guarantee at all of how many dollars
you'll wind up with in your account. Instead, the amount in a retirement nest egg with a defined contribution plan depends on the size of annual contributions (yours and your employer's)
and the rate of return (growth) on your invested funds.
Benefits are Usually Fully Insured
The Pension Benefit Guaranty Corporation (PBGC) covers most defined benefit pension plans. PBGC is a federal agency set up to insure that benefits under this type of plan (up to
a maximum amount) are paid to an employee, even if the retirement plan becomes insolvent. No such insurance exists for defined contribution plans.
Making Investment Decisions
With a defined benefit plan, the plan administrator makes the investment decisions for the employees. With a 401(k) plan (and often with other types of defined contribution plans),
employees can direct their own investments under the plan provisions.
Transferring Plans
If you leave a job before the plan's normal retirement age, your retirement benefits payout depends on the type of retirement plan. When you have a defined benefit plan and you
leave your job, your pension benefits are often held and administered by your former employer's plan until you reach the "normal" retirement age (typically age 65). But check your
plan as some defined benefit plans let you begin collecting benefits before normal retirement age.
With a 401(k) plan and other defined contribution plans, you can typically can receive your benefits immediately after employment ends, at any age. When you receive a defined contribution
or defined benefit plan payout in a lump sum, you can roll over your retirement account benefits to an IRA or another plan with your new employer.
Calculating Pension Benefits
There are three factors you can use to calculate pension benefits under a defined benefit plan:
1. A fixed percentage rate for each
year of work
2. How long you've worked for your employer
3. Your final salary
For example, let's say a plan gives you a retirement benefit
of 1% of your salary for each year of work. So 30 years
of work for the company would bring you a pension equal
to 30% of your salary for life.
Differences in Defined Benefit Plans
Every plan can have different provisions. You need to look at the Summary Plan
Description provided by your employer's plan administrator to find out the specifics
of your company's plan. Some of the ways plans may differ from company to company
include how salary is defined, reductions for social security, retirement age
and vesting.
How Salary is Defined
When calculating salary into the retirement formula, employers may use:
1. Your final annual salary
2. An average of your five highest paid years of service
3. Another formula
Reductions for Social Security
Under some plans, the plan benefit formula calls for a reduction relating to
Social Security. This reduction is commonly referred to as Social Security integration.
For example, an integrated plan calling for a 40% pension could really mean that
the company pension benefit would be added to a portion of your Social Security
benefits. Together the two benefits would total 40% of your salary.
Normal Retirement Age
Benefits usually start to be paid out at what is called "normal retirement age." Companies
have some choice in selecting the normal retirement age for their plans.
Vesting
Your rights to benefits vest when they become non-forfeitable, when you own them.
This all depends on the plan's vesting period. That's basically about how long
you'll have to work before you own the rights to the benefit.
Private, non-governmental plans must let you vest (own) in one of these ways:
1. 20% after 3 years of service and an additional 20% for
each additional year (100% vesting within 7 years - also known as graded vesting),
or;
2. No vested interest until after specific years of service and
then you are 100% vested (also known as "cliff vesting"), or;
3. A more liberal, faster vesting plan either selected by your employer
Governmental plans may have different provisions
The Size of the Pension Benefit
Companies are not required by law to pay you a benefit of a certain size. But
defined benefit plans usually pay larger pensions to employees who stay for a
longer period of time. Generally speaking, you'd be wise to stay with one company's
defined benefit pension plan rather than participating in a series of plans at
different companies.
Pension plans with private companies seldom adjust pensions for increases in
the cost of living. So, a pension benefit of 30% of final salary for life will
give you diminishing buying power as the years go by and as inflation increases
the cost of living. On the other hand, government pension plans often include
cost-of-living adjustments.
The Effect of Changing Employers
Whenever taking a new job or are thinking of leaving an old one, always check
out the retirement plan consequences. Not all plans are created equal.
For more information:
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Charles M. Bloom, Registered Principal offers securities
and advisory services through Centaurus Financial, Inc. - 214 Calle Palo Colorado, CA, 93105 (mailing address: 3905 State Street Suite 7173, Santa Barbara, CA, 93105) - Member FINRA and SIPC.
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