What Is a Defined-Benefit Plan? Examples and How Payments Work

A defined-benefit plan is an employer-sponsored retirement plan where employee benefits are computed using a formula that considers several factors, such as length of employment and salary history. Usually, employees are required to work for a specific amount of time before they become eligible to participate in the plan. They might also require a waiting period after breaks in service.

The company is responsible for managing the plan's investments and risk and will most often hire an outside investment manager to oversee the plan. Typically an employee cannot just withdraw funds as with a 401(k) plan. Rather, they become eligible to take their benefit as a fixed monthly payment like an annuity or, in some cases, as a lump sum at an age defined by the plan's rules.

Understanding Defined-Benefit Plans

Also known as pension plans or qualified-benefit plans, this type of plan is called "defined benefit" because employees and employers know the formula for calculating retirement benefits ahead of time, and they use it to define and set the benefit payout. This fund is different from other retirement funds, like retirement savings accounts, where the payout amounts depend on investment returns.

Since the employer is responsible for making investment decisions and managing the plan's investments, the employer assumes all the investment and planning risks. Poor investment returns or faulty assumptions and calculations can result in a funding shortfall, where employers are legally obligated to make up the difference with a cash contribution.

Examples of Defined-Benefit Plan Payouts

A defined-benefit plan guarantees a specific benefit or payout upon retirement. The employer may opt for a fixed benefit or one calculated according to a formula that factors in years of service, age, and average salary. The employer typically funds the plan by contributing a regular amount, usually a percentage of the employee's pay, into a tax-deferred account. However, depending on the plan, employees may also make contributions. The employer contribution is, in effect, deferred compensation.

Upon retirement, the plan may pay monthly payments throughout the employee’s lifetime or as a lump-sum payment. For example, a plan for a retiree with 30 years of service at retirement may state the benefit as an exact dollar amount, such as $150 per month per year of the employee's service. This plan would pay the employee $4,500 per month in retirement. If the employee dies, some plans distribute any remaining benefits to the employee's beneficiaries.

The Bottom Line

If you understand how a defined-benefit plan works, you can plan your retirement more strategically.

For example, you might choose to work another year, because working another year increases your benefits. (It increases the years of service used in the benefit formula.) This extra year may also increase the final salary your employer uses to calculate the benefit. In addition, there may be a stipulation that says working past the plan's normal retirement age automatically increases an employee's benefits.