Finance

What is Defined Benefit Pension Plan?

What is Defined Benefit Pension Plan?

Pension plans are investment plans that let you allocate a part of your savings to accumulate over a period of time and provide you with steady income after retirement. It ensures income flow to continue well beyond retirement.

There are 2 main types of pension plans:
a) Defined Benefit (DB) and
b) Defined Contribution (DC).

Defined benefit plans are more commonly known as traditional pension plans nothing but employer-sponsored retirement plans.

Things to Know about Defined Benefit Plans
1. Promises to pay a certain amount of retirement income for life.

2. The amount of pension is based on a formula that usually takes into account your earnings and years of service with your employer.

3. In most plans, both you and your employer contribute.

4. Your employer is responsible for investing the contributions to ensure there’s enough money to pay the future pensions for all plan members.

5. If there’s a shortfall in the money needed, your employer pays the difference.

6. Like other qualified plans, they offer tax incentives both to employers and to participating employees.

7. Sample formula – 2% x your average salary in the past 5 years x number of years you were a plan member.

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For Example:
Average Salary ₹ 5,00,000
Benefit percentage of 2%
Years of plan membership 30
Formula calculation 5,00,000 x 2% x 30
Annual pension ₹ 3,00,000

Benefits of Defined Benefit Pension Plan

With a defined benefit plan, an employer promises its employees a certain pay-out on retirement. And that pay-out is based on a set formula that accounts for several factors such as years of service, age, and earnings history.

There is no cost to the employee and the pay-out is guaranteed.

Benefits paid are typically guaranteed retirement income for life. Many defined benefit plans permit employees to convert their future income into a lump-sum payment at retirement.

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Risk Involved

• The company bears the investment risk because it promises to pay employees a fixed benefit and must make up for any investment losses.

• On the negative side, the employee has no input in how the funds are invested and some defined benefit plans do not offer adjustments for inflation.

• Defined benefit packages can succumb to the pressures of costs and the volatility of investment markets.

• Long Vesting, Restricted withdrawal of Funds, High Concentration of Risk

Author: Deepika Shenolikar

About the Author: Deepika Shenolikar is professionally qualified as CFA Chartered. She is currently pursuing GARP FRM Certification and associated with NSDL Payments Bank as an Assistant Manager in the Risk Management domain.

Related: What is Moral Hazard Risk?

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