Defined benefit plans are a type of employer-sponsored retirement plan. These plans differ from other qualified plans in that they incentivize both the employer and the employees. Employers are able to deduct contributions made to the plan, and employees will not owe taxes on those contributions until they start taking distributions from them (usually during retirement).
Defined benefits can be a significant source of retirement income. They are typically capable of replacing 70 percent or more of your income before your retirement when combined with Social Security payments. Under defined benefit plans, you also do not have to worry about the performance of investments—you know exactly how much money you’ll get when you retire, so you don’t have to stress about market performance. In addition, these benefits are typically insured up to a certain amount by the federal government.
There are federal rules that govern how these plans can be used. Let’s take a closer look at what you should know about these plans and their potential role in your retirement planning.
Understanding defined benefit plans
With defined benefit plans, the amount of money you receive depends on age, years of service and salary. Retirement benefits under such a plan get calculated based on a formula that can provide a certain dollar amount every year you work for that employer. They can also provide a certain percentage of earnings.
A lot of retirement plans calculate the benefits for employees by determining an average of that employee’s earnings over the last several years of their employment, or by averaging the employee’s earnings for their entire career. They then take a certain percentage of that average and multiply it by the number of years that employee worked for the company.
The way those retirement benefits are paid out can also vary. Some of the options include:
- Lump sum payment: You receive the entire value of your retirement plan in a single lump sum, and will not receive any further payments. This is unlikely to be the case for people with particularly large amounts of benefits owed to them.
- Single life annuity: You receive a fixed monthly amount of money every year until you die, with no further payments made to survivors after your death.
- Qualified joint and survivor annuity: You receive that monthly benefit until your death, and after your death your surviving spouse receives those benefits (at least 50 percent of them) until their death.
Remember: defined benefit plans are not the same as defined contribution plans. The latter focus on contributions made to the plan. Under such a plan, you are entitled to a certain contribution amount each year, but the employer is not obligated to pay any specific amount at retirement. The amount you get depends on performance of investments.
What are cash balance plans?
Another type of retirement plan is the cash balance plan, which guarantees an employee a set amount of money upon their departure from their employer, instead of a guaranteed monthly income. These accounts are federally insured and their amounts are based on factors like duration of employment. If you leave your employer for a new position, the funds can be transferred to your new employer’s retirement plan or an IRA, although you’ll want to discuss the tax implications with your financial advisor.
For more information about defined benefit plans and how they work, we encourage you to contact the team at Fiduciary Advisors Ltd. with any questions you have. We will be happy to assist you!