What Is a Defined Benefit Plan?

Defined benefit (DB) retirement plans are far less common in today’s market, but that doesn't mean they’re any less valuable.

DB plans, like traditional pensions, have long offered stable, predictable benefits that guarantee life-long income and long-term security for retirees. However, many employers shied away from offering DB plans due to their high costs, volatility and complexity.

But new, innovative plan designs and hybrid defined benefit models are changing that consideration.

Modern defined benefit plans enable employers to combine the security and predictability of traditional DB plans with greater flexibility, customized options, and reduced risks. As more Americans struggle to save enough for retirement, these strategic advantages can help organizations attract and retain top talent while supporting employees’ long-term retirement goals.

Interested in learning how your organization can leverage DB plans to their full potential? Let’s take a more detailed look at how DB plans are structured, their advantages and disadvantages, and the pivotal role they can play in solving the retirement crisis.

Key takeaways

• Defined benefit plans provide guaranteed lifetime income for employees and significant tax advantages for both employees and employers. They offer a reliable, predictable income stream for participants throughout their retirement that’s shielded from market volatility.

• Defined benefit plans help organizations attract and retain top talent, but they also come with some management challenges to consider.

• Modern defined benefit plan designs enable employers to combine the security and predictability of traditional DB plans with greater flexibility, customization, and less risk.

What Is a Defined Benefit Plan?

Defined benefit (DB) plans are employer-sponsored retirement plans that provide employees with guaranteed benefits based on a predetermined formula.

Unlike 401(k) plans, defined benefit plans provide a reliable and predictable income stream for retired employees. DB plans also offer significant tax benefits for the employers who sponsor plans and the employees who participate in them.

Qualified defined benefit plans operate within the requirements set forth by the Internal Revenue Code and the Employee Retirement Income Security Act (ERISA). They must meet rigorous regulations to ensure they provide fair, equitable benefits and adequate protection for plan participants while maintaining proper financial and operational standards required for tax advantages.

How Does a Defined Benefit Plan Work?

In a defined benefit plan, employers promise to deliver a fixed retirement income, which is based on factors like an employee’s salary, age and length of service. The employer, acting as the guarantor, shoulders the investment risks and ensures the plan's solvency.

Employers typically cover the full costs of defined benefit plans, though there are some plans where employees also contribute.

There is a perception that DB plans are risky for sponsors. While short-term fluctuations in investment performance may result in cost volatility, well-managed plans can effectively mitigate these concerns through strategic investment choices.

Actuaries play an important role in managing defined benefit plans. That role includes calculating the future benefits due to be paid out and determining the necessary employer contributions required to sustain payouts. This process ensures that the plan remains adequately funded to meet its obligations to retirees, balancing current assets against future liabilities.

Types of Defined Benefit Plans

There are two main types of defined benefit plans: traditional pension plans and cash balance plans. Lets take a closer look at each

Traditional pension plans

Traditional pension plans are what most people think of when they talk about defined benefit plans.

To fully qualify for pension benefits, employees usually must work a certain number of years — known as the vesting period — to receive full retirement benefits. If someone leaves their job before meeting this requirement they won’t receive full benefits from the plan. Participants who stay with their employer until retirement receive benefit payouts based on the plan formula, typically based on their age, length of service and final salary level.

Traditional pensions were once a common and integral part of retirement benefits, but employers began phasing out pensions in the 1980s due to their long-term financial burden, administrative complexity and volatility. The high costs and unpredictable expenses associated with pensions weren’t worth the risk. Instead, many companies transitioned to defined contribution plans, such as a 401(k), that offer flexible retirement solutions, but place the investment risk on employees rather than the employer and also typically require employees to contribute to the plan in order to receive any employer contributions.

Cash balance plans

Cash balance plans offer a modernized, hybrid approach to defined benefit plans. In a cash balance plan, employees maintain an individual account that grows each year through employer contributions (typically a set percentage of an employee’s salary) and interest credits. Upon retirement, employees can take their benefits in a lump sum or convert them into an annuity at favorable rates. If they leave their job before reaching retirement, they can roll over benefits into individual retirement accounts (IRAs) or another retirement plan.

A cash balance plan looks similar to 401(k) as both are account based plans. Employees can check their account balance and track progress toward their retirement goals. But unlike a 401(k), employees don’t contribute directly to the plan. The employer retains the investment risk, ensuring the promised interest credits are covered by investment returns regardless of market fluctuations.

Interest credits in older cash balance plans are typically either a “fixed rate” where the crediting rate is a fixed rate of return or tied to Treasury yields. Either of these crediting methods creates avoidable risk and can result in contribution volatility. Modern plan designs, such as market return cash balance plans, remove that risk. Because assets and liabilities tend to move in lockstep, these plans have predictable and stable costs.

What Are the Advantages of a Defined Benefit Plan?

When designed and managed effectively, defined benefit plans can be advantageous for both participants and plan sponsors. A few key benefits of a defined benefit plan include:

Fixed payout

One of the most significant benefits of a defined benefit plan is the assurance of guaranteed lifetime income. These plans provide retirees with a steady, predictable income, allowing for precise budgeting and financial planning throughout retirement. This guaranteed income stream provides retirees with a solid foundation for retirement.

Improved employee retention

By offering a substantial retirement benefit that rewards long-term employment, employers can demonstrate a long-term commitment to their workforce. As a result, companies can better attract job seekers, enhance job satisfaction and encourage employees to stay with the company for the long haul.

Beyond mere compensation, a defined benefit plan represents a commitment to an employee's future, often leading to a more engaged, dedicated and loyal workforce. It’s no surprise that organizations that have DB plans frequently report a notable improvement in employee retention rates.

Tax advantages

Defined benefit plans offer significant tax advantages for both employers and employees. For employers, contributions made to the plan are deductible on their corporate tax return. For employees, benefits are tax-deferred, which means they don’t pay taxes on these funds until they retire and potentially fall into a lower tax bracket.

What Are the Challenges of a Defined Benefit Plan — and How Can They Be Managed?

Despite their strengths, defined benefit plans also come with certain challenges, including scalability issues, lengthy vesting periods and elevated risks for employers.

Limited protection from inflation

In a defined benefit plan, retirement benefit amounts are set in advance. This predetermined nature ensures stability but it also means that retirees won’t be protected from inflation, nor will they benefit from rising investment or stock market trends. Such a structure can limit the growth potential of retirement benefits and leave retirees vulnerable to inflationary pressures, with fixed payments anchored to predefined levels regardless of fund performance or the rising cost of living over time.

Increased risk

For employers sponsoring defined benefit plans, investment risks are an important consideration. Employers are solely responsible for funding the plan, managing its investments and ensuring that promised benefits are paid out. This responsibility includes absorbing the costs related to administrative tasks, market volatility and the potential for longer-than-expected lifespans of participants. These risks are quantifiable and manageable.

These challenges underscore the importance of meticulous plan management. You may also consider October Three's Pension Risk Transfer solution, which is designed to help employers manage and mitigate the risks associated with their defined benefit plans. This service transfers pension liabilities from the employer's balance sheet to an insurance company, which then takes on the responsibility of making future pension payments to retirees. This strategy reduces economic volatility and uncertainty, helping companies stabilize their financial outlook and focus more on their core business operations.

Defined Benefit Plan Payment Options

Under a defined benefit plan, retiring employees are typically presented with two options: annuity payments or lump-sum distributions. Each choice offers distinct advantages and implications for financial planning, tax considerations and overall financial security.

Annuity payments

Annuity payments are a series of regular, fixed payments that provide a steady stream of income over the retiree’s lifetime. This option guarantees a regular payout similar to receiving a paycheck, facilitating easier budget management and financial planning in retirement.

Employees can also opt for a joint and survivor annuity in their retirement plan, which provides the participant’s surviving spouse with a continuing fixed monthly benefit after the participant dies.

Lump-sum payments

Some defined benefit plans provide the retiree with the option to take the benefit in a lump sum, in which they receive the entire value of their defined benefit plan in one payment. While a lump sum option offers maximum spending flexibility, it also requires the retiree to manage, invest or allocate their retirement funds.

How Are Benefits Calculated in Defined Benefit Plans?

In defined benefit plans, retirement benefits are calculated using a specific formula that considers an employee’s years of company service, earnings, and age.

Often, the formula involves averaging the salary over the final years of employment — or sometimes over the entire career — applying a designated percentage to this average and then multiplying by the total years of service.

Defined Benefit Plans vs. Defined Contribution Plans

In a defined contribution (DC) plan — such as a 401(k) or profit-sharing plan — retirement benefits depend on employees’ contributions and the performance of the investment options chosen by the employee. In contrast, benefits in a defined benefit plan are predetermined and guaranteed by the employer, including benefits for surviving spouses.

While defined contribution plans offer participants some degree of flexibility and growth potential, it also requires employees to take charge of their retirement planning, including navigating the complexities of investment strategies and market risks. This introduces variability in retirement benefits, directly tying the success of an individual's retirement savings to their investment strategy, market conditions and ability to save.

While defined benefit and defined contribution plans each have their strengths, it’s not a one size fits all approach. DB plans are great at providing lifetime income and security and a DC plan provides employees with the flexibility they need to tailor their approach. Hybrid plans, such as cash balance plans, blend elements of defined benefit and defined contribution plans — providing the predictability of DB plans with the flexibility, transparency and individualized account that come with a DC plan.

October Three's Approach to Defined Benefit Plan Design

At October Three, we believe that well-structured defined benefit plans help attract and retain employees by offering retirement security and provide a tangible ROI to the employer. Defined benefit plans, and cash balance plans, in particular, can position your company as a forward-thinking, employee-centric organization committed to the long-term well-being of your workforce.

With retirement solutions built around efficiency, engagement, workforce planning and financial risk management, October Three can help your retirement plan deliver sustainable and stable results.

Whether you're looking to design a plan from the ground up or revitalize an existing one, our team is equipped with the expertise and experience to guide you. Our modern designs reduce volatility and leverage the value of your defined benefit and defined contribution plans by offering solutions that are:

• Fully customizable - designs that meet your organization’s unique needs.

• Aligned - with your organization’s goals and objectives.

• Less risky - for both employees and employers.

• Financially affordable and sustainable - to ensure consistent expenses year over year.

• Economical - using automation to improve the employee experience while reducing operational costs.

Contact us to learn how you can build a retirement program that provides better outcomes for you and your employees.

Defined Benefit Plan FAQs

How are defined benefit plans paid?

Defined benefit plans offer participants a choice in how their retirement benefits are distributed. Some of the ways defined benefit plans can be paid include:

• A single life annuity that provides a fixed monthly income for the lifetime of the participant with benefits stopping upon the participant/s death.

• A lump-sum payment that delivers the entire plan's value at once; no additional payments will be made to a retiree or their survivors.

• A joint and survivor annuity ensures that after the participant’s death, a surviving spouse continues to receive a fixed monthly payment that is usually at least 50% of the original amount.

What are the advantages of a defined benefit plan?

Defined benefit plans offer significant advantages, including the promise of stable, guaranteed monthly income during retirement. DB plans can also help organizations attract talent, build employee loyalty and improve retention over time.

What are the disadvantages of a defined benefit plan?

Employees may find defined benefit plans challenging due to their long vesting periods and limited control over investment decisions affecting their retirement benefits. They may also feel bound to their job until eligibility for full benefits is reached. For employers, the challenge with DB plans involves the financial responsibility of funding guaranteed benefits and managing the investment risk to ensure plan solvency.

Why are defined benefit plans offered to employees?

Defined benefit plans are offered to provide employees with a clear and predictable retirement income. This greatly contributes to job satisfaction and loyalty and aids employers in attracting and retaining a skilled workforce.