Defined benefit plan

Definition

A defined benefit plan is a type of pension plan where an employer guarantees a specific retirement benefit amount for employees based on a predetermined formula, typically considering factors such as salary history and years of service. This plan shifts the investment risk from the employee to the employer, as the employer is responsible for ensuring that there are sufficient funds to meet future obligations to retirees.

5 Must Know Facts For Your Next Test

1. Defined benefit plans provide a predictable income for retirees, which can help with long-term financial planning.
2. Employers bear the responsibility for managing the investments and ensuring that the plan remains adequately funded to meet future obligations.
3. The funding of defined benefit plans is subject to regulatory requirements, including minimum funding standards set by government agencies.
4. The formula used to calculate retirement benefits can vary widely among different plans, often based on factors like average salary during the employee's career and years of service.
5. Defined benefit plans have become less common in recent decades, with many employers shifting towards defined contribution plans, where retirement income depends on individual contributions and investment performance.

Review Questions

• How does a defined benefit plan differ from a defined contribution plan in terms of risk and benefits for employees?
  • A defined benefit plan guarantees a specific retirement benefit amount based on a predetermined formula, which shifts the investment risk onto the employer. In contrast, a defined contribution plan relies on employee contributions and investment performance, placing the risk on the employee. This means that while defined benefit plans offer more predictable retirement income, defined contribution plans can result in variable retirement savings depending on market conditions and individual investment choices.
• What factors influence the funding status of defined benefit plans and how do they impact employers' obligations?
  • The funding status of defined benefit plans is influenced by various factors, including investment returns, demographic changes such as mortality rates, and changes in workforce size. These factors affect the employer's obligations since they must ensure that enough funds are available to meet promised benefits. When funding levels fall short due to poor investment performance or increased longevity among retirees, employers may be required to make additional contributions to fulfill their obligations under the plan.
• Evaluate the long-term implications of declining participation in defined benefit plans for employees and employers in the current economic landscape.
  • The decline in participation in defined benefit plans has significant long-term implications for both employees and employers. For employees, this shift can lead to greater uncertainty regarding retirement income, as they must take on the responsibility of saving and investing for their future through defined contribution plans. For employers, this trend may reduce their long-term liability associated with pension obligations but can also impact employee recruitment and retention, as prospective workers often value the stability provided by traditional pension plans. The transition could result in a workforce that is less financially secure in retirement, potentially increasing reliance on social safety nets.

Related terms

pension fund: A pool of assets set aside by an employer to pay for employee retirement benefits, managed by a financial institution or investment firm.

actuarial assumptions: Estimates used in pension planning to predict future events, such as mortality rates, investment returns, and employee turnover, which affect the funding of pension plans.

vesting: The process by which employees earn the right to receive benefits from a pension plan after meeting certain requirements, such as length of service.