Planning your Retirement: Understanding Defined Benefit Plans

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By Guest writer Del Lewis

In the article, Saving For Retirement: 5 Things Every Young Professional Must Know, we introduced the concept of defined benefit plans and defined contribution plans. In the first case, you are guaranteed a fixed amount upon retirement, whereas in the latter case (DC plans), you bear the investment risk and you end up with more or less than you expected. This article will focus on defined benefit plans.

What is a Defined Benefit plan?

Defined Benefits, also known as salary-related or final salary pensions, are a type of retirement plan that promises a fixed amount payable to the participant upon retirement. The plan is generally sponsored by an employer and both employee and employer can benefit from tax incentives.

In order to maximise pensions’ stability, all defined benefit plans are required to comply with regulatory requirements. For example, contrary to DC plans, the employer is required to prove through an annual actuarial evaluation, that the pension fund is solvent and has enough money today to be able to pay the employees the promised benefits upon their retirement.

How Defined Benefit plans Work

A Defined Benefit plan entitles the holder to receive pre-determined benefits upon retirement. Age, salary and the number of years in service, will all affect the amount received.

Employers, the government and employees contribute to the plan over a number of years. Employees may need to remain in the plan for a vesting period, before qualifying to receive the full retirement benefits promised to them. By law, a minimum amount may be paid into the scheme by each contributing party:

Calculating Retirement Benefits

A formula is used to calculate the amount of retirement benefit due, based on years of service, salary and accrual rate. For example, after 40 years of membership, Tom’s final salary is $30,000. The accrual rate is 1/60th. If his company’s pension formula is years of service x salary x accrual rate, Tom’s annual pension will therefore be 40 x 1/60 x $30,000 = $20,000. If Tom leaves the scheme early, the benefit rewarded will reflect this.

Choosing How to Receive the Retirement Benefits

Most Defined Benefit plans allow holders to choose from various options:

  • Lump Sum payment

A lump sum is given upon retirement, up to a certain value (for example 25% of the pension’s overall value). Taxes may apply upon withdrawal. However, by opting to receive your full pension all at once, you will not be covered for inflation risk. This means that if you chose not to reinvest your money, and instead keep your funds in a bank account (or under your mattress!), the value of your money will depreciate with time and your purchasing power from the time of your retirement to your death may quickly erode.

  • Single Life Annuity

This option allows you to receive a fixed monthly payment until death. It may be a better option than the lump sum amount, if the monthly payments are adjusted for inflation and taxed at a lower rate.

  • Qualified Joint and Survivor Annuity

This option grants you a fixed monthly payment until death, whereupon at least 50% of the payment is transferred to your surviving spouse, civil partner or dependent child. A lump sum may also be payable.

Which Defined benefit option to choose?

Pension plans can be frequently amended over years. For example, from the time you start with an employer to the moment you leave or retire, the plan formula may change, the amounts of your benefits may be adjusted, and the Normal Retirement Age may be re-assessed. Also, other features like the payment options and membership conditions may change. Finally, external factors like taxation, demographic changes or regulation may also impact the amount you were initially entitled to receive. It is therefore advisable to discuss the various options with a financial advisor in order to choose which one will suit you the most. Plus, most of those options may apply differently if you decided to take your retirement earlier than the Normal Retirement Age (generally 65).

About the author: Del is a HR Consultant with a vast experience in pension administration and investment. Del contributes regularly to numerous business & finance blogs, and collates his some of own experiences on his own blog, The Risk Rut. You can also keep up with Del on Twitter – @DelLewis87.

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