Defined Benefit Pension Plan
A pension is a regular payment to a person that is intended to allow them to live comfortably without working. This mainly takes the form of a retirement pension, but it can also represent disability pension/benefits. In Canada, every member of the work force over 18 years old is required to contribute to the Canada Pension Plan (CPP). With an increasing cost of living, longer life expectancies, and increased expectations for the standard of living during retirement, however, many individuals opt to contribute to additional pension plans. Most employers now offer some form of pension or retirement savings plans for their staff.
One of the two main types of optional pension plans available is the defined benifit plan. This type of plan provides an individual with a specified amount on an annual or monthly basis for the lifetime of their retirement, paid by their employer. Contributions to these plans are not taxed; however, the benefits are upon receipt. In a defined benefit pension plan, employers and employees contribute to a Pension Fund, which is invested by the Pension Fund Trust. Most plans will specify the age at which an individual can retire (usually around the age of 65), though this is often flexible at the expense of a change in the regular payment received upon retirement i.e. a reduction if an individual retires early and so is likely to receive the benefit for longer.
The amount each individual will receive is usually worked out using one of three types of benefit formulae, which depend on factors like years of service (i.e. years as a member of the plan) and their earnings (salary):
final or best average earnings formula;
career average earnings formula; and,
flat benefit formula.
Final or Best Average Earnings Formula
Where the final or best average earnings formula is used, for each year of service, an individual receives a fixed percentage of their final salary or a fixed percentage of their average salary over a fixed period of time. This essentially means they will receive more during their retirement if they earn more during their working lifetime.
$50,000 (an individuals average salary (based on the best 5 years of earnings)
x 25 (total years in the plan)
x 0.02 (an example fixed percentage of 2%)
= $25,000 per year
The final average formula is commonly the formula used in the United States, with the final 3 to 5 years of earnings being used in the formula.
Career Average Earnings Formula
Where the career average earnings formula is used, an individuals monthly pension benefit will be a fixed percentage of their average annual earnings whilst a member of the plan. As with the final or best average earnings formula, this also means they will receive more during their retirement if they earn more during their working lifetime.
$50,000 (an individuals average salary whilst a member of the plan)
x 0.01 (an example fixed percentage of 1%)
= $500 per month
Flat Benefit Formula
Where the flat benefit formula is used, an individuals monthly pension benefit will be a fixed dollar amount for each year they are a member of the plan.
x 25 (total years in the plan)
= $1,250 per month
In the majority of cases, an individual will sign a form on commencemnt of employment allowing their employer to automatically deduct these contributions from their salary, and will receive pension plan documents that describe the formula used and the benefits that can be expected. In the United Kingdom, these benefits are often indexed for inflation.
As the nature of the formula used for defined benefit plans typically produce a J-shaped accrual pattern of benefits, the current value of benefits does not accelerate significantly until an individual is mid-career. This type of pension also tends to be harder to transfer to a new plan, for example when an individual moves companies, than a defined contribution plan due to the difficulty of valuing the amount accrued.
For a company trying to calculate the cost to them of a defined benefit plan they will need to perform complex calculations making assumptions regarding their employees average retirement age and life span, the returns earned by the pension plan's investments and taxes or levies, such as those required by the Pension Benefit Guaranty Corporation in the U.S.
The defined benefit plans usually pay their benefits for life, so there is no risk to the individual that their retirement fund has been invested unwisely by their employer producing low returns or that they will outlive their retirement income. This major advantage is the very reason that many employers no longer offer this type of plan.
The other major type of private pension plan is the defined contribution plan. Some employers also offer a combination of the defined benefit and defined contribution plan, known as hybrid or combination plans, which have become increasingly popular.