By Ian Berger, JD
Like cassette tapes and slide rules, defined benefit (DB) plans are becoming relics of the past. It’s estimated that 88% of private sector employees with a company plan in 1975 were covered by a DB plan. Today, that number is less than 20%.
One reason is the advent of 401(k) plans and other defined contribution plans. Another reason is the decline of the unionized workforce, since DB plans have traditionally been collectively-bargained. Most importantly, DB plans have become increasingly expensive. Congress has tightened the plan funding rules, which has led to higher employer contribution requirements. Also, plan sponsors must employ an actuary and pay premiums to the Pension Benefit Guaranty Corporation (PBGC), a quasi-governmental agency that insures DB plan benefits up to a certain level.
But many companies still sponsor DB plans. Here is a primer on how they work:
DB plan participants receive a benefit based on the plan’s formula. A typical DB plan formula consists of:
- A multiplier, which can be any percentage that the plan sponsor wants to use.
- The average of highest consecutive annual salary over a certain period of employment.
- Years of service with the plan sponsor.
Example: Let’s assume your DB plan provides an annual benefit of 1.0% x average three-year highest consecutive salary x years of service. Let’s say your highest three consecutive years of salary are $95,000, $100,000 and $105,000, and you retire with 25 years of service. Your annual benefit would be 1.0% x $100,000 x 25, or $25,000.
Most DB plans do not allow (or require) employee contributions. The benefit is typically fully funded by the plan sponsor.
The benefit determined under the plan formula is expressed as a periodic payment in the plan’s “normal form.” For ERISA-covered DB plans, the normal form for married participants is an annuity that pays a benefit over the participant’s lifetime and, if the spouse outlives the participant, pays the spouse 50% of that benefit over the spouse’s lifetime. For single participants, it is an annuity over the participant’s lifetime only. DB plans typically offer other forms of annuity payments, but most do not offer lump sum distributions. This means that most DB plan distributions cannot be rolled over.
DB benefits are payable when a participant reaches the plan’s normal retirement age (NRA). NRA is typically age 65. Most DB plans also pay a reduced benefit for participants who leave employment before NRA, as long as the termination date is after the plan’s “early retirement date” (e.g., after age 55 with at least five years of service). Participants who leave before their early retirement date can receive a deferred benefit if they are vested. DB plans cannot allow in-service distributions, hardship withdrawals or loans.