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Defined Benefit Pension Plans for Retirement

Defined benefit plans are a type of retirement plan that provide an employee with a fixed and guaranteed income after retirement. This income can be in a regular income form or a lumpsum form.

These plans have become less common in recent years. However, many individuals still have access to these plans through their employer or a union. Understanding how defined benefit pension plans work and their benefits can be crucial for planning a secure retirement.

Let's explore the basics of defined-benefit pension plans and their advantages and disadvantages.

What is a Defined Benefit Plan?

A defined benefit plan is a type of retirement plan in which an employer promises to pay a specific benefit to the employee upon retirement. This benefit is calculated based on a formula that typically considers the employee's salary, years of service and age at retirement. 

Thus, ‘defined’ means that the benefit to be received is defined through a formula known in advance.

Defined benefit plans provide retirees with a fixed and guaranteed income for life, which can benefit those who do not want to worry about managing their retirement investments or outliving their savings.

How Does a Defined Benefit Pension Plan Work?

In a defined benefit plan, the employer is responsible for the contributions and for seeing that the corpus reaches the promised retirement benefits.

Once an employee retires, they receive the accumulated retirement benefit in a payout option of their choice. The benefit amount is usually calculated using a formula that considers the employee's salary and length of service with the company.

They must work with the employer for a certain period before getting the right to this benefit. This period is known as the vesting period. However, if they quit before completing this vesting period, they may not receive the complete benefits. 

Real Life Illustration of Defined Benefit Pension Plan

Let's consider the case of Raghu, who works for a company that offers a defined benefit pension plan.

The plan stipulates that the retirement benefit is calculated based on the formula: 2% of the average of the last 5 years of salary multiplied by the number of years worked.

Raghu has been working for the company for 30 years, and the average of his last 5 years of salary is ₹8,00,000.

According to the formula provided by the pension plan:

Retirement Benefit = 2% of ₹8,00,000 (average salary) × 30 (years of service)

Retirement Benefit = 0.02 × 8,00,000 × 30 Retirement Benefit = 4,80,000 per year.

In this scenario, upon retirement, Raghu would be entitled to receive an annual pension benefit of ₹4,80,000. The company Raghu works for has been contributing to the pension plan throughout his employment to ensure that upon retirement, the plan has enough funds to provide Raghu with this defined benefit.

Raghu’s pension plan also comes with a vesting period of 5 years, which means Raghu must have worked for the company for at least 5 years to have the right to receive pension benefits. Since Raghu has worked for 30 years, he is well beyond the vesting period and fully entitled to his pension benefits. If Raghu had decided to leave the company before completing 5 years of service, he would not have been eligible to receive the complete pension benefits as outlined by the plan.

Benefits of Defined Benefit Plans

The major benefits of a defined benefit plan are:

A Secure Retirement

A defined benefit plan guarantees a specific retirement income to employees based on their years of service and salary history, thus providing the employees with secured financial protection after retirement.

Improved Retention for the Employer

Employers are responsible for funding the defined benefit plan and making any necessary contributions to ensure the plan is well-funded. This takes the burden off employees and ensures that there is enough money to pay out retirement benefits.

Employees perform better and stay longer when they feel cared for, when the benefits provided by their employer go beyond their paychecks, to the well-being of their family and even to their retirement phase. 

Risk Management

Defined benefit plans offer risk management benefits to both employers and employees. Employers assume the investment risk associated with the plan, while employees are guaranteed a set retirement income regardless of market conditions.

Retirement Planning

Defined benefit plans provide employees with a clear understanding of their retirement income and can help them plan for retirement. Employees have an idea of what they will receive at the time of their retirement and can, hence, plan their future finances better. They can use the guaranteed retirement income from the plan to supplement other retirement savings and benefits.

Financial Cover for Spouse

The plan does not cover just the employee's retirement, but in an unfortunate case when the employee dies, the surviving spouse keeps receiving a percentage of the benefits. 

Tax Benefits for the Employer

Being an employer-specific plan, where the employer is the primary contributor of funds, they are eligible for tax benefits. The contribution paid to the employees in the defined benefits plan is tax deductible for the employer. 

Types of Defined Benefit Plans in India

Defined benefit plans are differentiated based on their structure and the way benefits are calculated. Here are the two main types of defined benefit plans:

1. Pensions

The most common form, pension, is a type of defined benefit plan in which an employer promises to pay a specified monthly benefit to an employee upon retirement. The employee receives this benefit in the form of a monthly pension.

The benefit is usually calculated based on a number of factors, like the employee's years of service, salary history, and other factors. These plans are typically funded entirely by the employer, although some plans may require employee contributions.

2. Cash Balance Plans

In a cash balance plan, an account is set up and is maintained by contributions by the employer. These contributions are a certain percentage of the employee's salary. The account's balance also keeps on accumulating interest at a fixed rate, and thus, the corpus grows till the retirement of the employee. 

Thus, the employee has a pre-defined amount at the time of retirement. 

When the employee retires, they can choose to receive their account balance as a lump sum or as an annuity that pays a fixed monthly benefit for life.

What are Defined Benefit Plan Payment Options?

Defined Benefit Plans offer various payout options to cater different needs and preferences. Mostly, these options are chosen by the policyholders as per their preferences. The most commonly used payment options are:

1. Single Life Annuity

This option provides a steady income for life to the retiree only. Payments cease upon the death of the retiree, offering no benefits to survivors. It's ideal for individuals without dependents who prioritise maximising their monthly retirement income.

2. Lump-Sum Payments

Choosing a lump-sum payment allows retirees to receive their entire benefit in one go. This option offers flexibility for personal investment or other uses but requires careful financial management to avoid depleting funds prematurely.

3. Qualified Survivor and Joint Annuity

This option ensures that after the retiree's death, a designated survivor, often a spouse, continues to receive benefits. Payments are generally lower than the single life annuity but provide the security of income for dependents.

Each of the above options has its advantages and considerations, tailored to suit the diverse needs of retirees and their families.

Difference Between Defined Benefit and Defined Contribution Plan

Contrary to a defined benefit plan, the pension amount is unknown in the defined contribution plan.

Here, the employer and/or employee contribute a certain amount of money into the account. The contributions are invested, and they grow over time. Thus, the employee's retirement benefit is based on the amount of money that has accumulated in the account at the time of retirement.

The major differences between the two types of plans are:

Basis	Defined Benefit Pension Plan	Defined Contribution Plan
Benefit Structure	They promise a certain benefit amount at the time of retirement.	These allow regular contributions to be invested and grow. The final payout is based on the accumulated corpus that has grown over the years.
Contributions	Here, the employer is responsible for the contributions and to reach the targeted benefit.	Here, the employer may offer matching contributions, but the final payout largely depends on the employee contributions and investment performance.
Investment Risk	In defined benefit plans, the employer bears the investment risk, as they are responsible for funding the plan and ensuring that it can meet its obligations to employees.	In defined contribution plans, employees bear the investment risk, as the ultimate payout amount is based on investment performance.
Portability	Generally, not portable, although some plans may offer a lump-sum payout option.	More portable, meaning that employees can take their account balance with them if they leave the employer.

Ultimately, the decision between a defined benefit plan and a defined contribution plan depends on the employer's goals and financial resources.

Defined benefit pension plans are like a promise from your employer: they guarantee you a set income every month after you retire, no matter how the stock market performs. It's a bit like getting a steady paycheck even after you stop working. Your employer handles the investments and takes on the risk. This provides a secure and predictable retirement income, making it easier to plan for your golden years. However, these plans are becoming less common, with many companies shifting to other retirement savings options.

FAQs about Defined Benefit Pension Plans

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How are payouts calculated in a defined benefit plan?

Payouts are typically calculated based on a formula that takes into account the employee's salary history, years of service, and age. This formula is determined by the plan's actuary and is often complex.

Can employees contribute to a defined benefit plan?

Employees typically do not contribute to defined benefit plans. Instead, the employer is responsible for funding the plan.

Can employees withdraw money from a defined benefit plan before retirement?

In most cases, employees cannot withdraw money from a defined benefit plan before retirement. The plan is designed to provide retirement income and is not intended for other uses.

What happens if an employee dies before retirement?

If an employee dies before retirement, their designated beneficiary may be entitled to a survivor benefit under the defined benefit plan.

Can employees take a loan from a defined benefit plan?

No, employees cannot take a loan from a defined benefit plan. The plan is designed to provide retirement income and is not intended for other uses.

What happens if an employee works beyond retirement age?

If an employee works beyond retirement age, their defined benefit plan payout amount may increase, as the formula considers years of service and age.

What is a defined benefit plan of gratuity?

A defined benefit plan of gratuity promises a specific payout at retirement, calculated based on salary and years of service.

What is a defined benefit plan at risk?

A defined benefit plan at risk refers to a pension plan that is not financially secure, facing potential funding shortfalls. Its funding target attainment percentage (FTAP) for the previous year is less than 80%.

Is EPF a defined benefit plan?

EPF is considered a defined contribution plan, not a defined benefit plan.

Can you transfer a defined benefit plan?

If you are in a defined benefit pension, you can transfer out of it into a defined contribution pension if you haven't started taking an income from it.

How do you divide a defined benefit plan?

Defined benefit plans at risk might not have enough funds to pay future benefits.In India, there is no specific limit on the highest pension. Transferring a defined benefit plan is complex and often requires consent from the plan provider. Dividing a defined benefit plan, especially in cases like divorce, requires a court order and is typically managed by actuaries to ensure equitable distribution.

At what age should I start investing in a pension plan and insurance plan?

The earlier, the better! Start investing in a pension plan and life insurance in your 20s or early 30s. Early investment allows you to benefit from compound interest and lower insurance premiums, providing financial security and a substantial retirement fund over time. Starting early ensures better financial stability and protection.

How much coverage do I need for term insurance during retirement?

During retirement, term insurance plans should ideally cover outstanding debts, end-of-life expenses, and provide a financial cushion for dependents. A common recommendation is to have coverage equal to 5-10 times your annual income. However, individual needs vary, so it's best to consult with a financial advisor

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