What is a defined benefit plan?

A defined-benefit plan is one set up to provide a predetermined retirement benefit to employees or their beneficiaries, either in the form of a certain dollar amount or a specific percentage of compensation.

Employer contributions to a defined-benefit plan are very complex to determine and require the work of an actuary. The assets of the plan are held in a pool, rather than individual accounts for each employee, and as a result, the employees have no voice in investment decisions. Once established, the employer must continue to fund the plan, even if the organization has no profits in a given year. Since the employer makes a specific promise to pay a certain sum in the future, it is the employer who assumes the risk of fluctuations in the value of the investment pool.

There are three basic types of defined-benefit plans.

• Flat benefit plan: all participants receive a flat dollar amount as long as a predetermined minimum number-of-years requirement has been met.
  • Example : A plan calls for payment of 20 percent of average compensation for the last five years, or $500 per month, to each retiree with at least 10 years of service.
• Unit benefit plan: provides a benefit that is either a percentage of compensation or a fixed dollar amount multiplied by the number of qualifying years of service.
  • Example : A benefit of 2 percent of the average compensation of the five highest consecutive years, or a $20 monthly retirement benefit, for each year of service.
• Variable benefit plan: benefits are based on allocating units, rather than dollars, to the contributions to the plan. At retirement, the value of the units allocated to the retiring employee would be the proportionate value of all units in the fund.

The maximum annual contribution that can be made to a defined-benefit plan is one that would be projected to yield a benefit equal to the lesser of $180,000 for 2007 (this amount may be adjusted for inflation periodically), or 100 percent of the participant's average compensation for the three highest consecutive years.

Very few defined-benefit plans provide for the benefits to be adjusted each year to reflect the effects of inflation (called the Cost of Living Adjustment, or COLA), so over the retirement years the value or purchasing power of the benefits may shrink considerably.

Reprinted with permission. © CCH