What is a defined benefit plan?

In Investment by CreatingWealthYoung0 Comments

A defined benefit plan is a pension plan that guarantees a certain amount of income upon retiring.  Defined benefit plans are often considered the gold standard for pension income as the income is not dependent on investment return performance.

How much pension will I get?

Broadly speaking, defined pension plans are based on a formula. The formula is usually a combination of the number of years worked, a determined amount of pensionable earnings per year earned, and your salary during your working years. The combination can vary among employers but as a generally rule what you are entitled to is a combination of those three factors. That being said, the most common form is what’s referred to as career average. In short, the employer takes an average salary during your career years, multiplied by the pensionable earnings you earn per year and then multiplied by your pensionable service year.

Let’s use an example to illustrate the career average plan. Please note this is a made up example for illustration only. Let’s assume you work for an employer with the following pension formula. You are able to earn 3% pensionable earning based on the average of the best 5 years of your earning for a maximum pensionable service year of 25 years. Now, let’s assume your best 5 years’ average salary worked out to be $30, 000.00. In this case, you would be entitled to a pension income of $22, 500 per year ($30,000*3%*25). Not too bad, considering you would receive that income indefinitely throughout your retirement regardless of what the market is doing and of course assuming your employer doesn’t go out of business.

What is vesting?

Vesting is an important thing to know if you have a defined pension plan or any benefit that has a vesting period. When your pension becomes vested; it means you are entitled to any pension benefits you have earned and more importantly any pension benefit you employer owes you as well. Before such a time, you are only entitled to anything you’ve paid into the plan and not what your employer has been putting away for you.

Every pension has a different vesting period that can range from 1 year to 10 plus years. As such, it’s important you are aware of the time frame you’re required to be part of the plan to be entitled to both you and your employer’s contribution.

Why are employers moving away from defined pension plan?

Two reasons; increased risks and employees living longer. That’s the simple and honest answer. Here’s the thing. When an employer offers a defined pension plan they are agreeing to fund your retirement income regardless of what’s happening in the world or the company. Employers invest their contribution and their employee’s contribution either directly or indirectly in the stock market. Upon retirement, the employer bears all the responsibility with respect to funding your pension income. And since employers in some form or another are investing your pension in the market, they expose themselves to normal market ups and downs.

And since employees are now living longer, employers are on the hook for a longer period than in the previous generation. I haven’t even discussed the reduced labour force factor. Defined benefit plans are becoming increasingly difficult to fund given our higher life expectancy, increased investment risks, and changing labour force. But I must add, it’s not impossible, just more difficult for employers today in the environment we live in.

 

What the future holds…

Uncertainty. That’s the word I would use to describe the future of defined pension plans. For the most part, private sectors are getting rid of their defined benefit plans for new employees. On the other side, public sectors are renegotiating their pension entitlement and moving towards a shared risk for new employees. In short, defined benefit plans glorious days are well behind it.

If you’re a young person and happen to work for an employer that offers a defined pension plan, good for you, but do not make the mistake of relaxing and assuming this is your pension plan. These plans are sure to undergo changes in some form or another during your working years.

Defined pension plans offer a consistent level of income during your retirement years. Take the time to speak to your human resource department to understand your pension formula. Be sure to ask them what the vesting period is. Lastly, avoid overspending or taking on additional risk if you happen to have a defined pension plan. It’s important to recognize that a lot can happen in 30 years. You still need to take ownership of your retirement planning and avoid putting that responsibility on someone else; especially when change is the only constant in life.

I’ve never heard anyone who complained about having more money than they anticipated they would upon retiring. Take ownership of your own life and future!