Defined Benefit Pension Plan

The Traditional Defined Benefit Plan ROCKS!

Defined Benefit Pension Plans are THE BEST! 

Employees are rewarded for their service with a lifetime pension when they retire. While public employees often aren't paid the same as private employees, they can receive a lifelong pension at retirement.

Many employers have opted out of this type of plan because of the liability the Employer assumes (a lifetime pension to you). Just think -- people live longer nowadays. If someone retires at 60, and lives to age 85, the employer will pay out twenty-five years of pension benefits.

How a Defined Benefit Pension Plan works:

While you are employed, the employer and employee pay contributions into the Employer Retirement fund. Employees contribute a fixed percentage of earnings. Employers contribute based on an annual actuarial study.

As a side note, if you look at the total amount the employee contributed over their employment of 20-30 years -- and what they receive as an annual retirement, in most cases, that contributed amount would have paid only a year (maybe a few years) of pension benefits. The majority of pension payments will be employer contributed funds and investment gains.

These funds are monitored by an actuary, annually, to assure the fund will provide the lifetime benefit. The actuary looks at the entire fund: new hires, employee deaths, disabilities, new retirees, retiree deaths, benefit levels, pay increases, and oodles of data. They advise the employer on the percentage of earnings they need to contribute during the year to keep the fund sound.

In good investment markets, the fund earns more so the employer is required to fund less... it's a good thing! However, in poor investment markets, the employer is required to contribute lots more, as they aren't earning the money the fund was a few years ago.

If there are a big number of new retirements (paying out more funds), the employer contributions increase. If they are a lot of retiree deaths (end of pensions), the employer contributions decrease. The percentage calculated by the actuary involves so many events in the retirement plan all mingled into one new contribution rate for the year.

That is the problem -- the employer has little control over how much money they will pay into the fund each year. Two percent one year (in a good financial market), and sixteen percent the next (in a down market).

For employers, it's really difficult to budget with Defined Benefit Pension Plans -- and part of the reason why so many employers have left DB Plans for more stable contribution rates with Defined Contribution (DC) plans. 

What are the benefits to a Defined Benefit Pension Plan?

LIFETIME PENSIONS for the retiree!

You earn the pension based on your years of service and earnings. You receive pension payments from date of retirement to date of death. You can also opt for a pension reduction so that your spouse continues to receive your pension at your death.

It's definitely a win-win retirement plan for the employee!

Defined Contribution Plans: One quick comment here -- all the folks with the newer 401K type of Defined Contribution Pension Plans were hit with BIG stock market reductions in bad markets. I remember hearing how retirees lost so much (and could never make it all back if they were close to retirement).

You can retire, and think you have plenty of cash set aside in your Defined Contribution plan, only to fall victim to a bad financial market. You lose a huge portion of what you've saved over twenty or thirty years!

Guess what? When the investments are gone, they are gone.

Sure, you might hit another good market (and it takes a long time to recover those funds), but if not, that was your lifetime retirement -- and it's gone!

THAT is the problem with Defined Contribution plans, they don't necessarily provide a lifetime income like Defined Benefit Plans do.

DB Pension Calculations

Defined Benefit Pension Plans usually have three basic factors in their calculations:

  • multiplier (employer chooses the factor or unions may negotiate it)
  • years of service (how long were you employed and in the retirement plan)
  • earnings average (usually a final average of 3-5 years of service)

For Example: Under Defined Benefit Pension Plan, if your company offers a 2% multiplier, and you retire after 15 years of service, with a $30,000 final average salary, the pension calculation is:

.02 multiplier
X 15 years
X $30,000 earnings
$9,000 annually or $750 monthly ($9,000 divided by 12)

Does it sound odd to you that you are multiplying:
(1) a percentage
(2) number of years of service 
(3) earnings 

It did to me too... but that is how Defined Benefit Pension Plans are calculated.

There are lots of variables... your employer multiplier might be 1.5% or 2.2%, or your final earnings average could be your last year earnings or a 3-5 year average.  The All plans differ a bit, of course...

Either way, think about it -- whatever the multiplier is, the longer you work, and the more you earn -- the higher the lifetime pension.

For example, if you work a lifetime for one employer with a Defined Benefit Pension Plan, you'll end up with one larger pension and it's based on the final average earnings (normally your highest lifetime earnings during the last five years worked).

You can figure out the percentage of your pension to your earnings like this - you worked 15 years at 2% per year so your pension is 30% of your average earnings (.02 x 15).... and yes, $9000/year pension is 30 percent of $30,000 earned.

Again, the longer you work, the higher your percentage of earnings is... this is a lifetime pension. Keep on working (unless you hit the maximum years) and get that lifetime pension maximized as you'll likely draw it for many, many years!

Net to Net Comparison

Finally, consider your Net to Net earnings in retirement versus when you worked. Do the net to net comparison, NOT gross to gross.

Why? When you work, the employer takes Federal tax, State tax, FICA, Union Dues, etc. out of your gross pay. When you retire, in most cases, you'll pay less taxes... some states don't require a state income tax on pensions, FICA is no longer necessary as you've retired, union dues are gone.

Just another thing to consider -- some public employees who have a long term employment and a good pension get closer to 100% of "Net take home pay", even though their pension is 60% of wages. 

Deferred Compensation Deductions: Some employees I worked with had large deferred compensation deductions. They chose to put money into an employer sponsored deferred comp plan voluntarily to accumulate a fund for retirement. When the deduction is large, the employee lived on less net earnings.

The odd thing that happened to some, is that they learned to live on less... so that when they retired they earned more than their working earnings, net to net, because they had voluntarily reduced their net spendable income while they worked.

As I worked on these calcs, I thought something was wrong and checked my math... but all proved correct. When I dived deeper into the calc, I saw the huge deferred comp deduction and was able to tell the employee what happened. Surprise!

p.s. The earnings that were deferred WERE counted in the gross earnings for the pension calculation. But when you look at spendable income before and after retirement -- that's when the surprise kicks in!

Questions? Use my Contact Wendy page.  I want to help you determine how to retire. I will  help with your pension calculation or explain your options... just ask!