By Lee Sherman
Defined benefit pensions, which provide guaranteed monthly payments to employees when they retire were once a reliable safety net. But they are rapidly dying off and most companies no longer offer them. Keeping up with inflation has proved difficult as has making sure they are continually funded. A basic understanding of how they work though can still help you decide whether they make sense for you, if your employer offers one.
What is a Defined Benefit Pension?
A defined benefit pension plan is one where your employer specifies an exact payment that will be applied to your retirement each month. Like a 401k plan where your employer matches the amount you put in, healthcare, or guaranteed bonuses, they should be considered an incentive for you to want to work at a specific company and included in your calculus of how much you’ll be making should you choose to join that company.
How much you’ll get is determined upfront and is based on a simple formula that includes your earnings history, how long you’ve worked at the company, and your age. In this sense, a defined benefit pension plan is more transparent than pension plans that are based on individual investment returns and that makes it easier to plan for your retirement.
While they aren’t as popular as they once were, defined pension plans are still offered by both government agencies and corporations. If you’re searching for a new job (as many are right now as a result of layoffs caused by the pandemic) you may be offered participation in such a benefit instead of a higher salary. You’ll need to make your own decision (perhaps in consultation with your financial planner) as to whether this is a trade-off that works for you and your family.
Consider too how long you plan to stay at a particular company. One of the major reasons why these plans are on life support is that the days of an individual staying employed by the same company for 30 years or so (giving them time to grow their pension) are long over. According to the Bureau of Labor Statistics, the median number of years that employees had been with their current employers is 4.2 years as of January 2016, down from 4.6 years in January 2014.
Another type of plan known as a defined contribution retirement savings plan provides transparency into the formula used to calculate the benefit but the exact amount of the benefit is not pre-determined.
How your benefit is determined
The formula used can vary but most companies base the benefit on your final salary. The exact benefit is determined by the percentage of average earnings for the years you’ve worked just prior to your retirement date. One important thing to note; in the private sector, defined benefit plans are typically funded by employer contributions while the public sector, they are funded by employee contributions.
These plans can be a good way to make sure you’ll have enough at retirement but that’s only if they have enough money in them to make that possible. Like social security itself, they remain in serious danger of running out of money.
Lee Sherman is a contributing writer to MyPerfectFinancialAdvisor, the premier matchmaker between investors and advisors. Lee is an experienced journalist and editor with over 30 years of expertise with a significant history of writing in the personal finance and technology arenas.