Understanding Defined Benefit Pension Plans (2024)

A defined benefit plan, more commonly known as a pension, offers guaranteed retirement benefits for employees. Defined benefit plans are largely funded by employers, with retirement payouts based on a set formula that considers an employee’s salary, age and tenure with the company.

In an age of defined contribution plans like 401(k)s, defined benefit plans are becoming less and less common, despite the retirement certainty and security pension plans can offer.

How Does a Defined Benefit Plan Work?

Defined benefit plans offer guaranteed salary-like payments and were historically offered in order to entice workers to stay with one company for years or even decades.

Thanks to the rise of lower-cost defined contribution plans, defined benefit plans are much less prevalent today. In 1980, 83% of private sector workers had a defined benefit plan as an option. By 2018, only 17% of private sector workers had the option.

The IRS considers a defined benefit plan to be a qualified employer-sponsored retirement plan. That makes them eligible for benefits like tax-deferred investment growth and tax deductions for certain contributions.

You’re probably more familiar with qualified employer-sponsored options like a 401(k) plan. Unlike 401(k)s, defined benefit plans are usually funded entirely by employer contributions, although in rare cases employees may be required to make some contributions.

How Are Pension Benefits Calculated?

The retirement benefits provided by a defined benefit plan are typically based on some kind of formula that considers factors like your time with the company, your salary and your age.

For instance, a company might offer an annual payout equal to 1.5% of your average salary over the final five years of your employment for each year you were with the company. If the latter amounted to 20 years, then you might see an annual benefit equal to 30% of your salary.

It’s important to note that there is no single method defined benefit plans use to calculate employee benefits.

The formula might be based on an employee’s average salary for their last three years with a company—or their last five years. It might also be based on the employee’s average salary for their whole career with a company—or there might be a flat dollar benefit, such as $800 for each year an employee has been with the firm.

If you are eligible for a pension plan, be sure to check how your benefits will be calculated.

Employers generally get tax breaks for contributing to these plans, but they’re also on the hook for providing the guaranteed payments to beneficiaries, no matter how the underlying investments in a plan might perform.

This is one of the biggest distinguishing factors between pension plans and 401(k)s, whose future payments are entirely reliant on unassured investment performance. In addition, the benefits in most defined benefit plans are protected, within certain limitations, by federal insurance provided through the Pension Benefit Guaranty Corporation (PBGC).

Defined Benefit Plan Payment Options

When it comes time to retire, you typically receive payouts in the form of a lump sum or an annuity . Deciding between the two can challenging, especially since there are different ways the annuity could be structured:

• Single life payment. You receive a monthly payment for the rest of your life, and if you die, your beneficiaries receive no further payments.
• Single life with term certain. You receive a monthly payment, and if you die before the specified term is over, your beneficiaries receive payments for a preset number of years.
• 50% joint and survivor. When you die, your surviving spouse will get monthly payments for the rest of their life that are equal to 50% of your original annuity.
• 100% joint and survivor. When you die, your surviving spouse will get monthly payments for the rest of their life that are equal to 100% of your original annuity.

Adding more stipulations to your annuity usually means you’ll get lower monthly payments. But if you’re in good health and expect to live a long life, you’ll usually get the most benefit from choosing annuity payments.

If you’re in poor health and expect a short retirement, a lump sum may be the best way to go. You may also choose to take a lump sum payment and invest it or use it to buy an annuity of your own.

Defined Benefit Plan Contribution Limits

Although employees generally have little control over their benefits, there are still annual limits for defined benefit plans. In 2023, the annual benefit for an employee can’t exceed the lesser of 100% of their average compensation for their highest earning three consecutive calendar years or $265,000. This is up from $245,000 in 2022.

Types of Defined Benefit Plans

There are two main types of defined benefit plans: pensions and cash balance plans.

Pensions

People typically understand a defined benefit plan to be a pension: A guaranteed monthly benefit starting at retirement, based on a formula that factors in how long a worker remained with a company and how much they earned.

To earn pension benefits, employees usually need to remain with a company for a certain period of time. After racking up the required tenure, an employee is considered “vested.” Pension plans may have different vesting requirements. For instance, after one year with a company, an employee might be 20% vested, granting them retirement payments equal to 20% of a full pension.

Vesting schedules are also a common part of defined contribution plans. About half of 401(k)s have some sort of vesting schedule for employer contributions.

Cash Balance Plans

Cash balance plans are defined benefit plans that grant employees a set account balance at retirement or when they leave the company, instead of a set monthly benefit. For that reason, many people think of them as a hybrid between traditional pensions and 401(k)s.

While employers still take on all of the investment risk associated with managing retirement funds, they do not guarantee indefinite benefit payments. Instead, you are guaranteed up to a certain cash balance.

Cash balance plans generally calculate benefits based on your total working years with a company, not just your last or highest earning period, meaning some people end up with fewer benefits if their companies switch to a cash balance plan from a pension plan.

Employers typically calculate the cash balance based on two factors: pay credits and interest credits. Typically, an employee’s account is credited each year with a pay credit (such as 3% of compensation from their employer). They’ll also receive an interest credit for what’s in the account (usually a fixed or variable rate linked to a benchmark such as the 30-year Treasury bond).

Each year, participants have an annual account balance that becomes theirs upon vesting and that they receive when they leave the company. They will usually have the choice to receive their balance in the form of an annuity that makes regular payments over time or to take the benefit as a lump sum, which they could roll over to an individual retirement account (IRA) or another company’s plan.

Defined Benefit Plan vs Defined Contribution Plan

Think of defined contribution plans as the new kid on the block, and defined benefit plans as the old pro. A defined benefit plan primarily requires employers to make nearly all contributions while a defined benefit plan expects employees to make most of the contributions—even though many employers may choose to provide some matching contributions.

While defined benefit plans generally guarantee either a monthly payment or set lump-sum payout, depending on your salary or how long you remain with a company, defined contribution plan payouts aren’t guaranteed—they depend on employee contributions and the performance of the underlying investments.

Defined benefit plans offer greater assurance of some returns, although you could achieve higher earnings by managing your own retirement funds.

Defined contribution plans are much more common than defined benefit plans, with 43% of private sector, state and local government workers participating in one. While they are no longer common among private companies, defined benefit plans remain prevalent in state and local governments, with 76% of public employees participating in a pension plan.

Defined Benefit Plan Advantages

• Dependable income. Benefits are guaranteed in a defined benefit plan, offering employees the security of a regular paycheck in retirement.
• Payments are insulated from market performance. No matter what the underlying investments do, the employee’s retirement benefit amount stays the same.
• Potential for spousal support. A spouse may be able to continue receiving guaranteed payments after the employee’s death.
• Employer tax benefits. Employers generally get a tax deduction for contributions to defined benefit plans.
• Improved retention. Defined benefit plans can keep employees with a company for a long period of time as they wait to vest and earn the most retirement benefits.

Defined Benefit Plan Disadvantages

• No investment choices. Employees have no say in what their money is invested in.
• It takes time to vest. If a company requires that an employee stay for five years to vest and the employee leaves after three, all the money they earned stays with the company.
• Lack of portability. It may be difficult to move money from plan to plan as an employee changes jobs, although this may be easier with cash balance plans. This doesn’t mean that you won’t still receive your total collective benefits in retirement. You’ll just have to keep up with multiple sources of income.
• No chance to increase your benefit. The benefit formula is the benefit formula, so an employee can’t improve their retirement paycheck. With defined contribution plans, employees can contribute more money or invest more aggressively to improve their returns. Those with defined benefit plans can also increase their retirement savings using IRAs, discussed more below.
• Expensive to maintain. Because they offer guaranteed payments regardless of market conditions, defined benefit plans are more expensive for employers to maintain than defined contribution plans.

How to Save for Retirement Outside of a Defined Benefit Plan

A defined benefit plan may not provide high enough payments for some employees. To determine if your pension will be enough to see you through retirement, calculate how much money you will need for retirement using our guide.

Once you’ve figured out how much you need to support your lifestyle, subtract your estimated payments from your defined benefit plans and Social Security. Then set savings goals to help you make up the difference.

Even if you have a pension, you can still save in tax-deferred accounts like traditional IRAs or after-tax accounts like Roth IRAs. In 2022, you can save up to $6,000 in an IRA, or up to $7,000 if you’re 50 or older. In 2023, that number increases to $6,500, or up to $7,500 if you’re 50 or older.

And if you don’t have a defined contribution plan but desire some of the security they provide, you can use your defined contribution plan plan—a 401(k) or 403(b), for instance—to purchase an annuity that provides a steady stream of income payments in retirement.

Annuities, however, aren’t for everyone and often charge high fees or require confusing and complicated contracts. Be sure to talk with a financial advisor to determine how annuities might fit into your retirement plan.