DEFINED BENEFIT PLANS
What is a Defined Benefits Plan?
Not as prevalent as they once were prior to 1980, these plans are written to define and fund a monthly benefit that is promised to you for life when you reach Normal Retirement Age. The employer bore the cost for these plans. These are the most complex and expensive to administer because an Actuary has to go through a complex series of calculations to determine how much the employer has to contribute to the plan each year to fund the participants’ benefits.
Examples of Defined Monthly Benefit Formulae
The monthly benefit payable at Normal Retirement Age will be 50% of the Participant’s Average Monthly Earnings (AME) based on his highest five consecutive calendar years of earnings. So, if an employee’s five highest consecutive calendar years’ of compensation equals $4,000, he will receive $2,000 per month commencing on the first day of the month following the month in which he reaches Normal Retirement Age.
Another example of a defined benefit formula would be, using an AME of $12,000 for our purposes, 24% of the participants AME up to the Social Security Wage base plus 20% of AME that is in excess of the Social Security Wage Base (which is $132,900 for 2019). So, for 2019 that calculation would look like this:
- $132,900 divided by 12 months = $11,075.
- $11,075 times .24 = $2,658
- $12,000 minus $11,075 = $925
- $925 times .2 = $185
- $2,658 plus $185 = $2,843
Therefore, the participant is accruing a monthly benefit, payable at Normal Retirement Age, in the amount of $2,843.
Some plans use a years of credited service formula which might look like this for a participant with 30 years of service and an AME of $4,000. Assume the benefit formula is 2% of AME times years of credited service.
- $4,000 times .02 = $80
- $80 times 30 years of service is $2,400
Therefore, the participant is accruing a monthly benefit, payable at Normal Retirement Age, in the amount of $2,400.
Early Retirement Reduction:
These plans also define at what age a participant can take early benefit (usually 55 if the Normal Retirement Age is 65). If you decide to retire early, your monthly benefit is reduced a bit because it is assumed that you will receive the benefit for a greater number of years than if you had waited to retire at 65. The plan defines what the reduction percentages are.
For example, the plans I used to service would state that if a participant decides to retire early and commence receiving his monthly benefit, that benefit would be reduced by 1/15 for each of the first five years earlier than Normal retirement Age and 1/30 for the next five years. So, if a participant retires at age 62 and wants to immediately begin receiving his monthly benefit, that benefit would be reduced by 3/15. If he elected to retire at age 57, his monthly benefit would be reduced by 5/15 for the first five years prior to age 65 and 3/30 for each year earlier than that.
Example: Ronald J. Chump is due to receive $1,000 per month if he retires at age 65. If he retires at age 62, his benefit would be reduced as follows:
$1,000 x 3/15 = 200.
$1,000 – $200 = $800
Therefore, he would receive $800 per month at age 62.
Under a defined benefit plan, you are guaranteed your monthly benefit for the remainder of your life regardless of how long you live. However, in the event you die first, if you would like your spouse to continue receiving this benefit for the remainder of his or her life, your benefit will be reduced.
If you choose to receive 1oo% of your monthly benefit with no reduction, that is called a Single Life Annuity. That means that when you die, the payments stop regardless of your date of death. Many men were doing this back when and their spouse’s were left high and dry when they died. I knew a woman whose husband died one month after he retired and she got nothing. Now, as a result of the Retirement Equity Act of 1988, you cannot take a Single Life Annuity unless your spouse signs off on it. And you can be fairly certain that your spouse ain’t gonna let you take a Single Life Annuity.
There are a couple of other annuity options that that remedy this situation:
100% Joint and Survivor: If you die first, your spouse will continue to receive the same monthly amount for the remainder of his or her life.
50% Joint and Survivor: If you die first, your spouse will continue to receive 50% of the same monthly amount for the remainder of his or her life.
Naturally, your monthly benefit will be reduced depending on which option you select.
Termination Prior to Normal or Early Retirement Age
You would receive, starting at your Normal Retirement Date, the monthly benefit you have accrued up to that point, or, you can elect to receive the lump sum present value of your monthly benefit. There are actuarial calculations that determine the present value.
You can then elect to roll it over into an IRA to avoid paying taxes on it until such time that you liquidate the IRA, or, you can cash the check and pay the taxes by including it your Federal Income Tax return for that year.
Cash Balance Plans
Defined Benefit Plans have decreased substantially since the 1980’s. Many employers using Defined Benefit Plans have replaced them with “Cash Balance Plans”. These plans are a hybrid of defined benefit and defined contribution plans. Find out more by clicking here.