Most seniors need an income source outside of Social Security to pay their bills in retirement, and that's where defined benefit plans sometimes come in. More commonly known as a pension plan, a defined benefit plan is an employer plan that guarantees workers a certain amount of money in retirement. Benefits are typically calculated based on length of service or employment history, and salary. Though defined benefit plans aren't as popular as they once were, they're still a source of economic security for countless Americans.
How defined benefit plans work
With a defined benefit plan, an employer promises its employees a certain payout in retirement. That payout is based on a preset (or defined) formula that accounts for factors such as length of service, age, and earnings history.
You'll typically see defined benefit plans offered by government and public agencies, though some for-profit companies continue to offer them as well. Generally speaking, defined benefit plans are funded exclusively by employer contributions, but in some cases, employees contribute a portion of their earnings.
When an employer offers a defined benefit plan, it is responsible for administering that plan and covering all of the costs involved. The employer is also tasked with making investment decisions and managing investments for the plan, and as such, any related risk is assumed by the employer.
Plan benefits are usually made available to employees once they reach a certain age or fulfill certain criteria. There are typically strict rules regarding withdrawals that employees must adhere to in order to avoid penalties. While some plans distribute benefits to employees as monthly payments, others provide a single lump sum payment upon retirement. Certain plans also distribute benefits to the beneficiaries of employees who pass.
Defined benefit plans versus defined contribution plans
A defined contribution plan is a type of retirement plan where employers, employees, or both make regular contributions, and future employee benefits are based on the dollar amount of contributions made and their eventual value based on investment growth. They differ from defined benefit plans in that they do not guarantee a specific benefit to be paid in the future.
With a defined benefit plan, employers are responsible for making sure there's enough money to pay employee benefits as scheduled, and employers assume all of the investment risk involved in the plan. With a defined contribution plan, individual employees assume all of the investment risk involved.
The most common type of defined contribution plan is the 401(k), where employees contribute a portion of their earnings and invest their money so it grows over time. In many cases, employers will offer to match a portion of employee contributions, but most of the burden of funding 401(k)s falls at the individual employee level.
Defined benefit plans are not only riskier for employers, but more expensive to maintain. With defined contribution plans, most associated administration fees are passed on to the employees who participate. For these reasons, defined benefit plans have become far less popular among companies. In fact, in 1998, 60% of Fortune 500 companies offered defined benefit plans to new hires, but by the end of 2013, that number fell to just 24%. This absence of defined benefit plans has, in turn, left more and more employees in a less secure spot financially with regard to retirement.
This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors. We'd love to hear your questions, thoughts, and opinions on the Knowledge Center in general or this page in particular. Your input will help us help the world invest, better! Email us at firstname.lastname@example.org. Thanks -- and Fool on!