Back to the Future: Three Things to Know about Defined Benefit Plans
Posted on Monday, October 29, 2018 by Rae Shanahan
Who doesn’t love a little nostalgia?
Some blasts from the past are better left as memories—like shoulder pads from the 1980s. But others can still be useful today, even when it comes to benefits. One such case is the defined benefit plan, a retirement savings vehicle that was common a couple decades ago but is now often supplanted by a 401(k) plan.
What are defined benefit plans? And could they make a comeback like other retro fashions? Here are three things to know about these retirement plans:
They’re consistent. A defined benefit plan is exactly what it sounds like—upon retirement, an employee receives a set amount of money based on salary and their length of employment, either in regular payments or a lump sum. The formula dictating how much an employee gets is known and established (i.e., “defined”). It’s very similar to a traditional pension plan, and if investment returns don’t cover the amount to be payed out to employees, the employer needs to make up that shortfall. Typically, the employer contributes a portion of the employee’s total compensation package—employees do not forgo any amount from their paychecks. And it usually takes a few years to become fully “vested,” at which point the employee can draw upon the full amount of their plan.
They’re rare. Given their higher cost for employers, defined benefit plans have become uncommon, much like pension plans. In fact, only 4% of private-sector workers have defined benefit plans these days, which is a decline from 60% in the early 1980s. In place of these plans is the common 401(k), which is a defined contribution plan. That means employees contribute to their account with a specified amount from their paycheck.
With 401(k) plans, employees also have more control over how their money is invested than they do with a defined benefit plan, which is entirely managed by the employer. Having a say in how they invest their money can be very beneficial for employees, although some employees end up feeling overwhelmed by choices and the complexity of investing, and they don’t participate in their company’s retirement plans as robustly as they should.
They’re attractive. For all these reasons—predetermined payout, no paycheck contribution, and no fund management needed—defined benefit plans are a remarkable relic from the past, especially for Millennials and younger workers who never had the option of a pension. In today’s war for talent, this type of retirement benefit can be a powerful tool for recruitment and retention, provided your company is comfortable with the risk and the level of effort required to manage such a fund. One option for employers is to offer both defined benefit and defined contribution plans. This way, employees get a guaranteed payout—perhaps set at a lower amount than traditional pensions. They can also supplement that money with a 401(k) fund they contribute to and with which they can take a more active role, in terms of investments.
Just as fashions come and go, it’s important to keep up with trends and ideas from the past that may have value today.
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