A defined benefit plan is an employer sponsored retirement plan in which the employer guarantees a fixed retirement income. The actuaries that are managing the company’s pension fund calculate the amount of contribution to be made by the employer to the fund in order to satisfy the requirements of the defined benefit plan. The liability of the payments to be made lies on the employer and he thus bears the risks associated with the volatility in the markets.
The benefit that an employee receives as a result of the plan is a function of several factors like age, compensation, the years of service, growth in salary etc.
It is different from the defined contribution plan in the way that the benefits received under defined contribution plan is subject to the investment decisions of the employee. They are not guaranteed by the employer and may not even make contributions.
The benefits to be received after retirement can take many forms such as onetime payment, periodic payments etc. It is one of the major sources of income for the retirees.
Advantage of Defined Benefit Plan:
• No Investment required: The company provides all the necessary contributions. Any funding from the employee’s end is completely voluntary.
• No decision making: Traditional retirement plans depend upon the employee’s investment. Thus they have to make sure that investment is done correctly. No such decision making is involded in case of defined benefit plan.
• Depends upon years of service
• In case of the employee’s death, their dependents are covered by the plan
• No amount os deducted by employeer from the employee’s regular salary
• Cost-of-living adjustments are considered
• Employee retention: This plan is most effective in case of longer service tenure. This encourages employees to remain with one organization
• Influence retirement: This plan can be used to encourage particular business strategies by proposing early retirement benefits
Disadvantages of Defined Benefit Plan:
• No control over investment: The employees have no say over the way of investment as the company handles it
• Fixed amount: The amount that will be received is usually predefined, thus the potential is limited. In contrast, traditional pension plans depend on the amount of investment that one can make.
• Most costly plan
• Administratively complex
• Tax applied in both cases of excess and insufficient contribution