Defined Benefit Plan

Explaining Defined Benefit Plans to Employees: Tips for HR

A defined benefit plan is a retirement arrangement where an employer promises a specified pension payment or lump-sum amount to employees upon retirement. This predetermined benefit is calculated using a formula based on the employee’s earnings history, tenure of service, and age, rather than depending directly on individual investment returns. Unlike other retirement schemes, these plans provide guaranteed income, making them one of the most secure retirement options.

The benefit formula in a defined benefit pension plan is defined and known in advance. Most commonly, these plans use a terminal earnings formula (final salary), where benefits are calculated as a percentage of average earnings during specific years at the end of an employee’s career. Additionally, some plans may specify an exact dollar amount per month multiplied by years of service.

Funding and Management

In private sector defined benefit plans, funding typically comes exclusively from employer contributions. Conversely, public sector plans often require employee contributions as well. The employer bears the responsibility for making investment decisions and ensuring sufficient funds exist to pay future benefits. Furthermore, the employer assumes the investment risk but can also benefit from investment surpluses.

Each year, employers set aside funds based on actuarial calculations that project the employee’s earnings upon retirement. These calculations consider multiple factors:

• Employee’s life expectancy
• Normal retirement age
• Potential interest rate changes
• Annual retirement benefit amount
• Possible employee turnover

Benefit Distribution

Defined benefit plans distribute their benefits primarily through life annuities, providing equal periodic payments (monthly, quarterly, etc.) for the remainder of the retiree’s life. Alternatively, some plans offer lump-sum payments upon retirement. Most plans also allow joint distributions, enabling a surviving spouse to receive 50% of the payment after the employee’s death.

Key Characteristics

Defined benefit pension plans have several distinctive features:

• Provide fixed, pre-established benefits at retirement
• Payments typically increase annually with inflation
• Cannot be accessed before retirement (no withdrawals or loans)
• Employers cannot retroactively decrease benefits
• Annual filing requirements with regulatory authorities

Legal Framework

In the United States, defined benefit plans are legally defined in 26 U.S.C. § 414(j) as any pension plan that is not a defined contribution plan. Organizations offering these plans must annually file a Form 5500 with Schedule SB and employ an enrolled actuary to determine funding levels.

Employers of any size can establish defined benefit plans alongside other retirement plans. However, these plans tend to be more complex and costly to establish and maintain than other retirement arrangements, despite allowing businesses to contribute and deduct more annually.

Defined benefit plans remain popular among large firms and government institutions, particularly for organizations that value employee retention and loyalty. Though less common than in previous decades, they continue to provide significant retirement security for many workers worldwide.

How does a Defined Benefit Plan work?

Defined benefit plans operate through a carefully structured formula that determines retirement benefits based on specific variables. The primary factors in this calculation include the employee’s salary history, length of service, and sometimes age at retirement. Unlike other retirement vehicles, these plans do not fluctuate with market performance since the benefit amount is predetermined by the formula rather than investment returns.

The employer typically funds the plan by contributing a regular amount, usually a percentage of the employee’s pay, into a tax-deferred account. Accordingly, an employer must make annual contributions based on actuarial calculations that project future obligations. These calculations account for multiple factors including:

• Employee’s life expectancy
• Normal retirement age
• Potential interest rate changes
• Projected annual retirement benefit
• Possible employee turnover

In most cases, employers are the sole contributors to defined benefit plans. Nevertheless, some plans may require or permit employee contributions to supplement the employer’s funding. Regardless of who contributes, the employer bears full responsibility for ensuring sufficient funds exist to pay promised benefits, regardless of investment performance.

A fundamental aspect of defined benefit plans is the vesting period. Employees must typically work for a specified number of years before becoming fully entitled to their pension benefits. If an employee leaves the company before completing this vesting period, they may forfeit part or all of their retirement benefits. This structure inherently rewards long-term employment with a single organization.

Benefit calculations follow specific formulas that vary by plan. For instance, a “dollars times service” plan might provide a set monthly amount per year of service. Consider an employee with 30 years of service in a plan offering ₹8,438.05 per month per service year – this would yield ₹253,141.35 monthly in retirement. Alternatively, Final Average Pay (FAP) plans calculate benefits based on earnings during the final years of employment.

To illustrate with another example: if a plan specifies a 2% benefit factor, an employee with 25 years of service and a final average salary of ₹10,00,000 would receive an annual pension of ₹5,00,000 (₹10,00,000 × 2% × 25) or approximately ₹41,666 monthly.

Upon retirement, benefits are typically distributed through life annuities – equal periodic payments continuing throughout the retiree’s lifetime. Moreover, most plans allow joint distributions, enabling a surviving spouse to receive 50% of the payment after the employee’s death. Some plans alternatively offer lump-sum payment options.

Subsequently, the funds remain inaccessible until retirement. Unlike defined contribution plans such as 401(k)s, defined benefit plans generally do not permit loans or early withdrawals. Additionally, employers cannot retroactively decrease promised benefits.

Given their complexity, defined benefit plans require ongoing professional oversight. Employers must annually file Form 5500 with Schedule SB, signed by an enrolled actuary who determines appropriate funding levels. This rigorous structure ensures the plan maintains adequate resources to meet future obligations to retirees.

Defined Benefit Plan vs Defined Contribution Plan

The fundamental difference between defined benefit and defined contribution plans lies in where the retirement responsibility falls. Whereas defined benefit plans guarantee a specific retirement amount, defined contribution plans promise only that certain amounts will be contributed to the retirement account.

Who manages the funds?

In defined benefit plans, employers bear full responsibility for fund management and investment decisions. The company selects investment strategies, works with financial advisors, and makes all decisions regarding asset allocation. Essentially, employers act as fiduciaries, making prudent investment choices to ensure sufficient funds exist to meet future obligations.

Conversely, with defined contribution plans, employees typically manage their own investments. While employers may offer a limited selection of investment options, the ultimate responsibility for selecting specific investments falls on the employee. Many workers either take excessive risk by investing too aggressively or minimize their growth potential by being overly conservative. Some plan sponsors offer professionally managed accounts or lifecycle funds for employees who prefer not to make investment decisions independently.

How are payouts calculated?

Defined benefit plans provide a predetermined retirement benefit based on a formula that typically considers factors like:

• Years of service with the employer
• Final salary or average of highest-earning years
• A multiplier percentage specified in the plan

The final amount remains fixed regardless of market performance or investment returns.

Alternatively, defined contribution plan payouts depend entirely on:

• Amount contributed by the employee and employer
• Investment performance over time
• Market conditions at retirement

The final balance consists of contributions plus or minus investment gains or losses, with no guaranteed amount. This explains why only the contribution amount is known in advance, while the ultimate benefit remains undefined until retirement.

What risks do employees and employers face?

In defined benefit plans, employers shoulder significant risks:

• Investment risk – if investments underperform, employers must use other financial resources to meet obligations
• Longevity risk – funding benefits for employees who live longer than anticipated
• Administrative burden – complex actuarial projections and high administrative costs

Nonetheless, employers also retain potential rewards when investments outperform expectations.

For defined contribution plans, employees face multiple risks:

• Investment risk – poor market performance directly reduces retirement income
• Longevity risk – possibility of outliving savings
• Contribution inadequacy – insufficient savings during working years

One significant challenge with defined contribution plans involves ensuring adequate retirement savings. Research indicates that contributions of 12-13% of pay for 40 years with prudent investment management should meet most retirees’ income needs at age 65.

Despite these differences, defined contribution plans have become increasingly prevalent, primarily due to reduced employer liability, lower administrative costs, and greater portability when employees change jobs. According to the Congressional Research Service, by 2021, while 68% of workers had access to either type of plan, only 15% had access to defined benefit plans.

Common payout options in Defined Benefit Plans

Defined benefit plans typically offer retirees several payout options for receiving their retirement benefits. Each option comes with distinct characteristics that may be more suitable depending on individual circumstances, life expectancy, and family considerations.

Single-life annuity

A single-life annuity provides a fixed monthly benefit that continues until the retiree’s death. This straightforward option typically offers the highest monthly payments among all distribution methods because it covers only one person’s lifetime. Under this arrangement, once the annuitant passes away, all payments cease, with no further benefits transferring to beneficiaries or surviving spouse.

Single-life annuities work through a simple process: after an initial lump sum or series of contributions, the plan begins making regular payments (monthly, quarterly, or annually) that continue throughout the retiree’s life. The amount received depends primarily on factors such as the annuitant’s age, health status, and the size of the initial investment.

This option proves most appropriate for:

• Older retirees whose spouses have their own retirement income
• Individuals whose spouses already have separate annuities
• Those who have additional joint coverage through other retirement vehicles
• Singles without dependents who want to maximize monthly income

Nonetheless, single-life annuities remain less suitable for married individuals whose spouses depend on shared income, as this option provides no survivor benefits.

Joint and survivor annuity

A joint and survivor annuity (also called Qualified Joint and Survivor Annuity or QJSA) extends payment coverage beyond the primary retiree to include a spouse, child, or dependent. Following the primary annuitant’s death, the survivor continues receiving benefits for their lifetime.

The payment structure typically offers several options:

• 100% joint and survivor annuity: Payments remain level throughout both annuitants’ lifetimes
• 50% joint and survivor annuity: Payments reduce by half after the primary annuitant’s death
• 66% or ⅔ joint and survivor annuity: Payments reduce to two-thirds after the primary annuitant’s death

Importantly, IRS regulations require that qualified joint and survivor annuities must pay between 50% and 100% of the original amount to the survivor. Many plans include guarantee periods, wherein if both annuitants die within a specified timeframe, payments continue to a designated beneficiary until the guarantee period ends.

For instance, a QJSA might provide ₹126,570 monthly during the retiree’s lifetime, then ₹84,380 monthly for the surviving spouse until their death.

Lump-sum payment

The lump-sum payment option delivers the entire value of the defined benefit plan in a single distribution. This alternative to annuity payments gives retirees immediate access to their full retirement benefit. Upon selecting this option, no additional payments are made regardless of how long the retiree or any survivors live.

Lump-sum distributions may appeal to retirees who:

• Want to manage their own investments
• Have immediate large expenses
• Desire greater flexibility in retirement spending
• Wish to leave an inheritance

Simultaneously, lump-sum distributions warrant careful consideration regarding potential tax implications and the responsibility of managing a substantial sum to last throughout retirement. Plan provisions ultimately determine where these funds can be deposited and what taxes may apply.

If the lump sum value falls below ₹421,902, the plan can pay this amount instead of an annuity without obtaining consent from either the participant or spouse.

Selecting the optimal payout option requires thorough evaluation of personal circumstances, financial needs, life expectancy, and dependent considerations, as this decision significantly affects the ultimate benefit amount received.

Tips for HR to explain Defined Benefit Plans to employees

Explaining complex retirement arrangements to employees requires strategic communication approaches from HR professionals. Given that approximately 86% of state and local government workers and 15% of private industry workers have access to defined benefit plans, effective explanation strategies are essential.

1. Use simple, relatable language

Avoid technical jargon when discussing defined benefit plans. Define terms like “vesting period” clearly, explaining that employees must work for a specified duration before becoming entitled to full pension benefits. Likewise, explain “accrual rate” as the percentage of salary earned toward pension for each year of service.

2. Share real-life examples

Utilize concrete scenarios to illustrate benefits. For instance, show how an employee working 25 years with a final average salary of ₹10,00,000 and a 2% benefit factor would receive approximately ₹41,666 monthly.

3. Explain how the benefit is calculated

Present the calculation formula transparently: Retirement Benefit = Accrual Rate × Years of Service × Final Average Pay. Clarify that longer service and higher final salary typically result in greater benefits.

4. Clarify payout options

Outline the primary distribution methods:

• Single-life annuity (payments until death)
• Joint and survivor annuity (continuing payments to spouse)
• Lump-sum payment (entire benefit at once)

5. Address common concerns

Anticipate questions about investment risk, employer responsibility, and vesting requirements. Emphasize that employers bear investment risk while employees benefit from predictable retirement income.

6. Provide visual aids or calculators

Develop tools that help employees visualize future benefits. Create a summary document explaining key plan terminology plus calculation examples. Consider interactive calculators demonstrating how changes in service years affect benefit amounts.

7. Offer one-on-one sessions

Arrange personal meetings with benefits specialists who can provide individualized advice based on specific employment situations. Similar to VRS’s approach, offer both virtual and in-person counseling options.

8. Keep communication ongoing

Beyond enrollment periods, maintain regular communication about the defined benefit plan. Conduct periodic education sessions throughout employees’ careers and provide comprehensive information in new hire welcome kits. Additionally, send periodic emails with benefit updates and reminders.

Why Defined Benefit Plans still matter today

Despite the growing prevalence of defined contribution plans, defined benefit retirement plans remain critically important in today’s retirement landscape. These traditional pension schemes continue to offer unmatched security in an increasingly uncertain economic environment.

The guaranteed lifetime income provided by defined benefit plans represents their most significant advantage. This predictable retirement stream allows retirees to budget precisely throughout their post-work years, shielding them from market volatility that could otherwise devastate retirement savings. Indeed, this protection proves especially valuable during economic downturns when investment-based retirement accounts may suffer substantial losses.

Notably, defined benefit plans transfer investment risk from employees to employers. This arrangement benefits workers who lack investment expertise or prefer not to manage their own retirement portfolios. Plus, these plans typically include spousal benefits, ensuring continued financial support for partners after an employee’s death.

For employers, defined benefit plans serve as powerful retention tools. By rewarding long-term employment through service-linked calculations, organizations can reduce costly turnover and maintain institutional knowledge. These plans also offer significant tax advantages for both parties—employers can deduct contributions on corporate tax returns while employees receive tax-deferred benefits.

Currently, defined benefit plans remain particularly valuable in sectors prioritizing employee loyalty, including public institutions, academic organizations, and established corporations. Although only 15% of private-sector workers had access to defined benefit plans as of March 2023, these arrangements continue providing essential retirement security, especially for lower-income workers.

Even though the retirement landscape continues evolving, defined benefit plans still represent one of the most effective mechanisms for ensuring financial stability throughout retirement. Their unique combination of security, predictability, and guaranteed income remains unmatched by alternative retirement vehicles.

Key Takeaways

Understanding defined benefit plans is crucial for HR professionals to effectively communicate their value and help employees make informed retirement decisions.

• Defined benefit plans guarantee specific retirement income based on salary, years of service, and age—unlike 401(k)s where benefits depend on market performance and contributions.

• Employers bear all investment risk and funding responsibility while employees receive predictable lifetime income, making these plans ideal for risk-averse workers seeking retirement security.

• Use simple language and real examples when explaining plans—show how a 25-year employee earning ₹10,00,000 would receive ₹41,666 monthly with a 2% benefit factor.

• Offer multiple payout options including single-life annuity (highest monthly payments), joint-survivor annuity (spousal protection), or lump-sum distributions based on individual needs.

• Provide ongoing education through visual aids, calculators, and one-on-one sessions to help employees understand vesting periods, benefit calculations, and long-term value.

• Emphasize retention benefits for employers as these plans reward long-term service, reduce turnover costs, and provide significant tax advantages for both parties.

Despite their complexity, defined benefit plans remain one of the most secure retirement vehicles available, offering guaranteed income that protects against market volatility and longevity risk—making them invaluable for comprehensive employee benefits packages.

FAQs

Curious about more HR buzzwords like crisis management, data driven recruitment, or diversity hiring? Dive into our HR Glossary and get clear definitions of the terms that drive modern HR.Explore Taggd for RPO solutions.