In the majority of cases, employees are aware of the existence of a pension plan, if one is offered by their employer. However, most employees are uncertain as to what type of pension plan they have. Is it a defined benefit or a defined contribution pension plan?
Defined Benefit Pension Plan
Within a traditional defined benefit pension plan, plan members or employees who opt in, are entitled to a guaranteed pension amount that is pre-calculated using some set formula. So for example, Kevin B. works for an employer (Acme Post Holes) were the defined benefit pension plan is calculated using 2% multiplied by his average salary in the last 3 years of employment multiplied by his total years of membership or employment.
If Kevin earned $75,000, $76,000 and $77,000 his last 3 years at Acme Post Holes, the formula to determine his pension would look like this:
2% x [($75,000 + $76,000 + $77,000)/3 years] x 30 years = $45,600 per year or $3,800 per month.
In a defined benefit pension plan, employers are still responsible for the pension payout even if the plans assets are not enough to fund the “defined” benefit. For this reason, and a few others, these plans are not as commonplace as they once were.
Defined Contribution Pension Plan
An alternative to a defined benefit pension plan is the defined contribution pension plan. Within a defined contribution pension plan, contributions are pre-set. Contributions can be made by employer, employee, or both. However, the ultimate benefit is not “defined.” Employees or plan members are entitled to the gross of their fixed contributions over the total number of years they have worked, plus whatever investment return or losses their plan has accrued. Unlike the defined benefit, where the employer bears all the risk, the plan members/employees bear the risk in a defined contribution plan.
It should be easy enough to determine your plan type and formula – Look in your pension booklet or reach out to your human resource representative. It’s important to know the type of pension plan your employer offers. It could mean the difference between receiving a yearly pension of $7,200 or $31,200 with the same salary history.
Don’t have a retirement plan in place? Let’s chat.