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Defined Benefit Plans

Defined Benefit Plans
Unlike defined contribution plans where benefits are based upon performance of contributions, defined benefit plans which promise a certain benefit at retirement (for example, 30% of salary for life). Although the long-term trend is towards defined contribution plans, defined benefit plans will still be around for a while.

With defined benefit plans, the employer usually makes all of the plan's contributions. Years ago it was fairly common to have employees contribute to defined benefits plans, but now it's rare.

Compare this to a typical 401(k) plan, for example, where you might, as an employee, make the primary contributions while your employer matches some or all of your contributions.

Contribution Limits
With a 401(k) plan, your contributions can't exceed $10,500 (in the year 2001 ). The total of your contributions and employer contributions made on your behalf to a 401(k) plan (and any other defined contribution plan sponsored by your employer) is limited to the lesser of 25% of your compensation or $35,000.

The defined benefit plan takes a different approach. An employer contribution can be the amount needed to fund a normal retirement benefit, up to the lesser of $135,000 (in the year 2001 ), or 100% of the average compensation in the three highest years of the employee's tenure.
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Retirement Benefit is Certain
The benefit level in a defined benefit plan is fixed, regardless of how poorly the retirement plan assets may perform in the market. If the rate of return is too low on defined benefit plan investments, your pension isn't reduced. Instead, your employer is required to make additional contributions to make up the difference.

With a defined contribution plan, there are no guarantees that the size of the pension benefit will relate to your salary. In fact, there is no guarantee at all of how many dollars you'll wind up with in your account. Instead, the amount in a retirement nest egg with a defined contribution plan depends on the size of annual contributions (yours and your employer's) and the rate of return (growth) on your invested funds.

Benefits are Usually Fully Insured
The Pension Benefit Guaranty Corporation (PBGC) covers most defined benefit pension plans. PBGC is a federal agency set up to insure that benefits under this type of plan (up to a maximum amount) are paid to an employee, even if the retirement plan becomes insolvent. No such insurance exists for defined contribution plans.

Making Investment Decisions
With a defined benefit plan, the plan administrator makes the investment decisions for the employees. With a 401(k) plan (and often with other types of defined contribution plans), employees can direct their own investments under the plan provisions.

Transferring Plans
If you leave a job before the plan's normal retirement age, your retirement benefits payout depends on the type of retirement plan. When you have a defined benefit plan and you leave your job, your pension benefits are often held and administered by your former employer's plan until you reach the "normal" retirement age (typically age 65). But check your plan as some defined benefit plans let you begin collecting benefits before normal retirement age.

With a 401(k) plan and other defined contribution plans, you can typically can receive your benefits immediately after employment ends, at any age. When you receive a defined contribution or defined benefit plan payout in a lump sum, you can roll over your retirement account benefits to an IRA or another plan with your new employer.

Calculating Pension Benefits
There are three factors you can use to calculate pension benefits under a defined benefit plan:

1. A fixed percentage rate for each year of work
2. How long you've worked for your employer
3. Your final salary
For example, let's say a plan gives you a retirement benefit of 1% of your salary for each year of work. So 30 years of work for the company would bring you a pension equal to 30% of your salary for life.

Differences in Defined Benefit Plans
Every plan can have different provisions. You need to look at the Summary Plan Description provided by your employer's plan administrator to find out the specifics of your company's plan. Some of the ways plans may differ from company to company include how salary is defined, reductions for social security, retirement age and vesting.

How Salary is Defined
When calculating salary into the retirement formula, employers may use:
1. Your final annual salary
2. An average of your five highest paid years of service
3. Another formula
Reductions for Social Security
Under some plans, the plan benefit formula calls for a reduction relating to Social Security. This reduction is commonly referred to as Social Security integration. For example, an integrated plan calling for a 40% pension could really mean that the company pension benefit would be added to a portion of your Social Security benefits. Together the two benefits would total 40% of your salary.

Normal Retirement Age
Benefits usually start to be paid out at what is called "normal retirement age." Companies have some choice in selecting the normal retirement age for their plans.

Your rights to benefits vest when they become non-forfeitable, when you own them. This all depends on the plan's vesting period. That's basically about how long you'll have to work before you own the rights to the benefit.

Private, non-governmental plans must let you vest (own) in one of these ways:
1. 20% after 3 years of service and an additional 20% for each additional year (100% vesting within 7 years - also known as graded vesting), or;
2. No vested interest until after specific years of service and then you are 100% vested (also known as "cliff vesting"), or;
3. A more liberal, faster vesting plan either selected by your employer
Governmental plans may have different provisions

The Size of the Pension Benefit
Companies are not required by law to pay you a benefit of a certain size. But defined benefit plans usually pay larger pensions to employees who stay for a longer period of time. Generally speaking, you'd be wise to stay with one company's defined benefit pension plan rather than participating in a series of plans at different companies.

Pension plans with private companies seldom adjust pensions for increases in the cost of living. So, a pension benefit of 30% of final salary for life will give you diminishing buying power as the years go by and as inflation increases the cost of living. On the other hand, government pension plans often include cost-of-living adjustments.

The Effect of Changing Employers
Whenever taking a new job or are thinking of leaving an old one, always check out the retirement plan consequences. Not all plans are created equal.

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If you'd like more information about how diversified investment advisors can help you achieve your financial objectives through personalized wealth or retirement and risk management strategies, please contact us. We welcome the opportunity to discuss your unique needs and how we may best meet them.

This page (formatted for versions 10.0 and higher of Internet Explorer) is updated regularly so check in from time-to-time to see new articles and updates. You can click on any underlined words on each page to see a specific wealth management topic in the left margin of each page.

Charles M. Bloom, Registered Principal offers securities and advisory services through Centaurus Financial, Inc. - Member FINRA and SIPC - 775 Avenida Pequena, CA, 93111 (mailing address: 3905 State Street Suite 7173, Santa Barbara, CA, 93105) - CA Life Insurance License No. 0A52786 - Centaurus Financial, Inc. and Shoreline Wealth & Investment Management are not affiliated companies.

The information contained in this web site is neither an offer nor solicitation of any security or service.


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