Defined benefit plan

Definition

A defined benefit plan is a type of retirement plan where an employer guarantees a specific payout upon retirement, based on factors like salary history and duration of employment. This means employees know exactly what they will receive when they retire, providing financial security for the future. The employer is responsible for managing the investments and assumes the investment risk, making these plans distinct from other retirement plans.

5 Must Know Facts For Your Next Test

1. The employer is responsible for funding the plan and ensuring there are sufficient assets to meet future obligations to retirees.
2. Pension expense reported in financial statements includes various components such as service cost, interest cost, and amortization of prior service costs.
3. Defined benefit plans are subject to regulation and must adhere to funding requirements established by government agencies to protect employee benefits.
4. These plans often provide greater retirement security compared to defined contribution plans since payouts are not directly tied to market performance.
5. Companies must regularly perform actuarial valuations to determine their pension obligations and assess funding status.

Review Questions

• How does a defined benefit plan differ from a defined contribution plan in terms of risk and financial security for employees?
  • In a defined benefit plan, the employer bears the investment risk and guarantees a specific payout at retirement, providing more financial security for employees. In contrast, a defined contribution plan places the investment risk on employees, as their retirement income depends on how well their investments perform. This fundamental difference means that employees in defined benefit plans can have more predictable retirement income, whereas those in defined contribution plans may face uncertainties based on market conditions.
• Discuss the components that make up pension expense for a defined benefit plan and how they impact financial reporting.
  • Pension expense for a defined benefit plan comprises several key components: service cost (the present value of benefits earned during the year), interest cost (the increase in pension obligations due to the passage of time), expected return on plan assets (income expected from invested assets), and amortization of prior service costs. Each component affects how companies report their financial position and results, influencing both profitability metrics and balance sheet health. This complexity requires careful calculation and transparency in financial reporting.
• Evaluate the long-term implications of maintaining a defined benefit plan for a company’s financial health and employee retention strategies.
  • Maintaining a defined benefit plan can have significant long-term implications for a company's financial health. While these plans can enhance employee retention by offering stable retirement benefits, they also require substantial funding commitments that can strain cash flow and impact capital allocation. Companies need to balance these obligations with other operational needs, making it crucial to regularly assess pension funding levels and investment strategies. As labor markets evolve and employee preferences shift towards more flexible compensation structures, companies must also evaluate whether their defined benefit plans remain attractive in attracting and retaining talent.

Related terms

defined contribution plan:

A retirement plan where employees and/or employers contribute a specific amount to an individual account, with no guaranteed payout at retirement.

pension obligation:

The total amount a company owes to its employees under its defined benefit pension plan, representing future retirement benefits.

actuarial assumptions:

Estimates used by actuaries to calculate the expected costs of a defined benefit plan, including life expectancy and investment returns.