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Explain Defined-Benefit Plans

A defined-benefit plan (DBP), also called a pension plan, is a retirement plan funded entirely by an employer; the employee does not contribute to this type of plan. At retirement, the employee is promised a specific payout amount that is calculated using a formula set by the company.

Advantages and Disadvantages

One advantage of defined-benefit plans is that these plans often pay out a large percentage of an employee’s final salary—as much as 30 to 50 percent—thereby making a significant contribution to that employee’s retirement plan. Since you as the employee do not contribute to the plan, you bear no investment risk. Sometimes the benefits of these plans can even be extended to a spouse, depending on the type of retirement payout you choose.

There are also disadvantages of defined-benefit plans. One disadvantage is that the payout benefits are considered taxable income, and taxes can significantly diminish your net benefit. Another disadvantage is that your company can change its plan policies over time—even after you retire—so there is no guarantee that your benefits will remain constant. Moreover, most plans require you to stay with the company for a specific length of time to become fully vested, or in other words, fully eligible for benefits. If you quit or lose your job before retirement, you may lose your benefits.

It is important for you to remember that nine out of ten defined-benefit plans do not provide for a cost of living adjustment (COLA). This means that inflation could significantly reduce your purchasing power during retirement. You should also be aware that some plans are unfunded, which means that the company does not put aside the money to pay retirement benefits, but instead pays retirement benefits out of the company’s current profits. If the company does not make the necessary profits, you may not get your retirement benefits. Finally, if you die before retirement, your surviving spouse will likely receive a reduced benefit.

Payout Formulas

With a defined-benefit plan, the company uses a payout formula to determine how much you will receive at retirement. This formula usually includes variables such as retirement age, average salary, and years of employment.

The following example shows a payout formula used by XYZ Corporation. Assume XYZ Corporation uses the following steps to calculate an employee’s annual retirement payout:

  1. Averages the employee’s five highest annual salaries within the last ten years
  2. Determines the employee’s total years of employment
  3. Multiplies the average salary by 1.5 percent (this is a percentage set by each company) and by the total years of employment—a maximum of thirty-three years (this maximum is set by each company)

Bill Smith has worked for XYZ Corporation for twenty-five years. The average of his five highest salaries over the last ten years is $60,000. Using this information, XYZ Corporation calculates his retirement benefit as follows: $60,000 * 0.015 * 25 = $22,500.

When Bill retires at the end of next month, he will begin receiving $22,500 each year for as long as he lives. This means that Bill will receive 37.5 percent of his average salary each year throughout his retirement.


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