Defined Benefit Pension Plan

The Traditional Defined Benefit Plan ROCKS!

Defined Benefit Pension Plans are THE BEST! Many employers have opted out of this type of plan because of the liability the Employer assumes (a lifetime pension to you).

How a Defined Benefit Pension Plan works:

While you are employed, the employer contributes towards the Defined Benefit Pension fund (and usually the employee does too).

These funds are monitored by an actuary, annually, to assure the fund will provide the lifetime benefit. Annually, 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 likely funds 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.

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 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!

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).

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 ROCK!

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 earnings average could be your last year earnings or a 3-5 year average. 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).

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 is 30 percent of $30,000.

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. 

Questions? Email me.. I want to help folks determine how to retire. I might be able to help with your pension calculation or explain your options... just ask!

More on Retirement Investment Planning here!