What is a Defined Benefit Plan?

A defined benefit plan is a type of employer-sponsored retirement plan. In a defined benefit plan, benefits are determined by a formula that indicates the amount an employee will receive upon retirement. The benefit amount is typically based on a number of factors, including the employee's average salary before retirement, age at retirement, and length of employment. Benefit amounts can be a specific dollar amount or a compensation percentage.

Many people consider a defined benefit plan a traditional type of type of pension plan. Usually the employer is responsible for making all contributions to the defined benefit plan. However, in some cases, employees make contributions as well. Typically, defined benefit plans are found in larger companies.

A defined benefit plan does not require employees to make investment decisions. The employer is responsible for making decisions and managing investments for the plan. Likewise, the employer assumes all investment risk. The assets of a defined benefit plan are held collectively, rather than in individual employee accounts. The employer is responsible for funding the plan as required, even during periods when the company fails to earn a profit.

Benefits from a defined benefit plan may be provided as a lump sum upon retirement or as monthly payments that continue for as long as the retired person lives. In some cases, defined benefit plans provide benefits to the employee's beneficiaries after the employee's death. Such details vary from company to company.

The three primary types of defined benefit plans are flat, unit, and variable benefit plans. A flat benefit plan requires the employer to pay all retired employees a fixed dollar amount, as long as a minimum number of years of service have been reached. For example, a flat benefit plan could require the payment of 30 percent of the average compensation amount paid to the employee for the final five years of employment. Alternatively, this type of plan could require a specific monthly payment to each employee who worked for the company for ten years or more.

In a unit benefit plan, the benefit amount is determined by multiplying the percentage of compensation or a specified dollar amount by the number of years of employment. For example, the benefit could be either five percent of the average compensation paid to the employee or a $50 a month benefit for each year the employee worked for the company in question. Actual amounts and percentages vary.

A variable benefit plan requires an employer to base benefit amounts on the allocation of units to plan contributions. In this type of defined benefit plan, the benefit amount is based upon a calculation of the units allocated to the employee upon retirement. The value of the employee's units are proportionate to the value of all the units in the fund.