What is a defined benefit plan?
A defined benefit plan is a type of pension offered by employers to provide employees with the promise of an income during their retirement years. These were very common in the private sector in the late 90's and early 00's and are sometimes known as final salary schemes. They're now much less common due to their relative cost for the employer, but many public sector pensions in the UK look very similar to this set up.
In this pension plan, the employer promises an income for life based on factors such as salary, years of service, and a predetermined formula (known as a commutation factor, it can be found in relevant pension paperwork). Unlike other pension plans, such as a defined contribution plans, the responsibility for funding and managing the investments lies with the employer. Defined benefit plans provide a stable and predictable income stream, which can offer financial security in retirement.
Key takeaways
- A defined benefit plan is a pension plan that offers a set income for life.
- The employer is responsible for funding and managing the investments.
- It provides a stable and predictable income stream in retirement.
How defined benefit plans work
A defined benefit plan is a retirement plan where your employer promises to pay you a specific benefit amount when you retire. Here's how it works:
1. Set income benefit: With a defined benefit plan, the employer offers the promise of a specific retirement benefit based on factors like your salary, years of service, and a predetermined formula (known as a commutation factor, which you can find on relevant pension documents). The benefit amount is usually a percentage of your average salary during your working years.
2. Employer responsibility: Unlike other retirement plans, such as defined contribution plans, where the employee contributes and manages the investments, in a defined benefit plan, the employer bears the responsibility for funding the plan and making the necessary investments to meet future obligations.
3. Stable retirement income: The main advantage of a defined benefit plan is the assurance of a stable and predictable income stream during retirement. Since the benefit amount is predetermined, you have a clearer picture of how much retirement income you'll receive each month, regardless of market fluctuations.
Real-world example
Let's say you work for a company that offers a defined benefit plan. The plan states that upon retirement, you'll receive 60% of your average salary during your final five years of employment. If your average salary during those years is £50,000, your annual retirement benefit would be £30,000 (£50,000 x 0.60).
When you retire, your employer is responsible for funding your benefit. They contribute to the plan and invest the funds to ensure they have enough money to fulfill their promise of paying you £30,000 per year during your retirement. If they fail to fulfil the promise, there are protections in place to ensure you receive some pension, but it might not be as much as you'd initially hoped. As a result, it's always worth having multiple provisions in place for your pension.
Final thoughts on defined benefit plans
A defined benefit plan is a retirement plan that guarantees a specific benefit amount based on factors like salary, years of service, and a predetermined formula. Unlike other retirement plans, the employer is responsible for funding and managing the investments.
This type of plan provides a stable and predictable income stream during retirement, giving you peace of mind and financial security. If you have access to a defined benefit plan, it's important to understand the terms, calculate the potential benefits, and factor them into your overall retirement planning.