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How a Defined Pension Plan Works?

A defined pension plan, like any other qualified plan, offers tax incentives both to employers and to participating employees. ERISA (the Employee Retirement Income Security Act of 1974) includes two types of retirement plans – defined benefit plans and defined contribution plans, according to the information published by the U.S. Department of Labor.

While a defined benefit plan assures a specified monthly benefit at retirement, a defined contribution plan does not guarantee a specific amount of benefits at retirement. Defined benefit plans are quite popular in state and local governments in the United States, with over three-fourths of the public employees participating in a pension plan.

How a Defined-Benefit Pension Plan Works

Under a defined benefit pension plan, an employer is required to make annual contributions to an employee’s retirement account. The plan administrators usually hire an actuary who calculates the future benefits that the plan must pay an employee and the amount that the employer must contribute to ensure those benefits, say experts at E.H.Thomson & Co. This amount is determined by several factors including the employee’s age, salary, and years of service with the organization.

However, the employees may have to work for a specific number of years before they have a permanent right to any retirement benefit under a plan. This period of employment required is referred to as “vesting.” If the employee leaves the job before fully vesting in an employer’s defined benefit plan, he/she will not be entitled to get full retirement benefits from the plan.

Defined Benefit Plan – Contribution Limits

Although employees usually have no control over how much is contributed, there is still a contribution limit for these plans. In 2020, the annual benefit for an employee couldn’t be more than the lesser of 100% of the employee’s average compensation for their highest three consecutive calendar years, or $230,000, according to an article published by Forbes.

How the Retirement Benefits are Paid

Several defined benefit plans offer different payment options to the employees. The common ones include:

  • A single-life annuity: Offers a fixed monthly benefit until death, after which no further payments are made to the survivors
  • A qualified joint and survivor annuity: Offers a fixed monthly benefit until death, after which the surviving spouse continues to receive benefits (in an amount equal to at least 50% of the benefit) until his/her death.
  • A lump-sum payment: Offers the entire value of the plan in a lump sum

It is important to understand the rules of the pension plan that are offered by the employers. The employees should be aware of how the benefits are calculated, the vesting schedule, and the payment option to receive the benefits.

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