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Financial Freedom

Defined Benefit Plans: What They Are and How They Work

A defined benefit plan is an employer-sponsored retirement plan. While similar to them, these types of retirement plans differ from alternatives like a 401(k) or 457 plan. One of the many differences is that a defined benefit plan includes a guaranteed benefit to be paid out upon retirement.

The key with these plans is that the formula to calculate the benefit is predefined. Retirement payouts are formulated ahead of time. This calculation usually factors in things like how many years of employment were served, age and salary.

Notebook on a desk containing a defined benefit plan

Each year you work for a company that provides a defined benefit plan, an actuary will recalculate future benefits. This includes updating key elements like years worked and salary revisions. This is one of many reasons that some people nearing retirement favor defined benefit plans… because benefit payouts are based on the latest salary figures, and salaries are usually highest shortly before retirement.

Another reason employees enjoy defined benefit plans is that the risk is on the employer. Unlike with a 401(k), ebbs and flows in the market don’t affect the recipient of a defined benefit plan. Their nest egg should remain safe and sound.

Calculating Retirement Benefits

Long before retirement rolls around, an employer should share the details of their plan. And knowing the formula will help set realistic retirement goals.

The payout of some employers’ defined benefit plans is based on the average salary of the last few years of employment. The payout will consist of a specified percentage (known as a pension factor) of the averaged-out salary multiplied by the number of years worked.

Here’s an example of what that looks like in practice…

Phil the plumber is on the cusp of retirement. For the last three years, his salary remained consistent at $77,000. His pension factor was 3%. And he worked for the company for a steady 30 years.

($77,000 x 3%) x 30 = $69,300

The most likely outcome here is that the defined benefits plan will result in 12 monthly payments of $5,775 a year. This of course is ignoring the taxable portion that is subject to federal income tax withholdings.

As you can see, each year worked is an important factor in the end result. And beyond the basic calculation, additional working years can result in an increased pension factor.

Not all defined benefit plans are paid out the same way, though…

How Defined Benefit Plans Can Be Paid

Under most circumstances, the employee gets to decide how they collect their benefits. Here are three of the most popular selections:

  • Lump-Sum Payment
    Just like it sounds, this is a single payment consisting of the entire value of the defined benefit plan. Once it’s paid out, that’s it. There will be no future payments made to the employee. Worth noting: This can result in an outsized tax burden.
  • Single-Life Annuity
    Like we calculated above, this consists of a fixed monthly benefit for the rest of the retiree’s life.
  • Qualified Joint and Survivor Annuity
    Like with a single-life annuity, the recipient will receive fixed monthly benefits for life. Upon death, a surviving spouse will continue to receive benefits for the rest of their life. In the case of the survivor, the payments are in an amount of at least 50% of the retiree’s benefits.

When it comes to payout options, it’s obvious that the option chosen can have a large impact on the amount received. This isn’t a decision to make willy-nilly. Consider all the options on the table. Compare their differences. And calculate how they will impact your retirement plans. For a decision this large, it’s not a bad idea to reach out to a financial consultant or tax planner for guidance.

How to Maximize a Defined Benefit Plans

If you’re already enrolled in a pension plan, you probably already know how valuable they can be to your future. But there are a few ways to increase how much you receive when it comes time to retire. Here are three ways to maximize the amount you receive when it’s time to retire.

  1. Delay Social Security
    Social Security is essentially the government’s version of a defined benefit plan. Both you and your employer pay into it in the form of payroll taxes. And we’re all supposed to receive a monthly check from the government once we retire.
    You can choose to receive your Social Security check as early as age 62. But the longer you wait, the larger the monthly check will be. In fact, it grows 8% every year you delay receiving it past retirement age.
  1. Leverage the Pension Formula
    Not to beat a dead horse, but make the most of the formula your employer uses to calculate defined benefit payments. Every additional year worked can add exponentially to the payout. Knowing this is crucial to planning and being able to retire comfortable. In the equation above, plumber Phil would receive close to $200 less per month if he retired one year earlier.
  1. Income Annuities
    These are special financial products that are designed to guarantee monthly or annual payments. Payments can start once a month after you pay the premium and can continue for as long as you are alive. These can be ideal for retirees concerned about outliving their retirement savings. They’re also a way to increase the size of a defined benefit plan check.

The Bottom Line on Defined Benefit Plans

Defined benefit plans aren’t as popular as they used to be. While employees enjoyed being able to predict how much income they would have in retirement, these plans can be a liability for employers. Funding a defined benefit plans can tap into a company’s profits. This is just one of the many reasons this type of retirement plan has given way to 401(k) plans.

Those lucky enough to be enrolled in one should take full advantage. But it’s worth knowing that, for the most part, you have to work a specific number of years before you have a “right” to any of the benefits. This is known as “vesting.” If you leave a job before being fully vested in the plan, you won’t get full retirement benefits from it.

Whether you’re enrolled in a defined benefit plan or not, there are plenty of ways out there to achieve financial freedom and retire comfortably. If you’re looking for tips, tricks and surefire investment opportunities to achieve your dreams, we suggest signing up for the free Wealthy Retirement e-letter. All you have to do is drop in your email address and wait for the help to show up in your inbox.


About

Matthew Makowski is a senior research analyst and writer at Investment U. He has been studying and writing about the markets for 20 years. Equally comfortable identifying value stocks as he is discounts in the crypto markets, Matthew began mining Bitcoin in 2011 and has since honed his focus on the cryptocurrency markets as a whole. He is a graduate of Rutgers University and lives in Colorado with his dog, Dorito.

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