How does a defined-benefit retirement plan work?


A defined-benefit retirement plan, as its name suggests, provides a specific desired benefit that an employee is due to receive upon retirement. The benefit amount is based on the wages earned and the length of service.

Varying contributions are invested into the retirement plan in order for the desired benefit amount to be reached. The most commonly used instruments for funding defined-benefit retirement plans are deferred annuities.

The most significant factors in determining the total retirement benefit are an individual's earnings and their years of service. Under current retirement plan provisions and federal law regulations, the longer you stay in the labor force, the higher the size of your pension benefit is likely to be. Frequent job-hopping or employment breaks can have a detrimental effect on your pension, leaving you inadequately protected after you retire.

Determining the Retirement Benefit Amount

There are a few methods, which can be used to determine retirement benefit amounts. Here are some of them:

  • The career-average earnings approach calculates the benefit amount on the basis of the average income of an employee while covered by the plan.
  • Under the final average pay approach, the average of an employee's earnings over the last few years before retirement is used to determine the benefit amount.
  • The unit-benefit formula takes into account both years of service and earned income of the employees.
  • According to another formula, a specified flat dollar amount is paid for each year of service.
  • Under the "flat percentage of annual earnings" formula, a certain fixed share of a retirement plan participant's earnings, typically between 25 and 50 percent, goes into funding the plan.

When an employer establishes a new pension plan for their employees, the company can grant older employees who are close to retirement with credits for their service in order to help them catch up.

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