A defined benefit pension provides a specified pension income, that calculated by using different methods such as a percentage of average earnings or average highest earnings and years of membership in the pension plan. The benefit is defined as up-front. A defined pension plan is a predetermined amount that allows employees and employers to save the guarantee amount for retirement, based on their take-home pay history, tenure of service and duration of the investment. The employer manages the investment to have longer capital at the time of retirement. Instead of relying on individual investment returns most of the by government workers, public entities, a large number of corporations and senior management groups, etc prefer a defined pension plan. There are three basic forms of defined benefit pension plans:
- Final and Best-Earnings
Example: Suppose Mr. Z has worked for 10 years, and his per month salary including bonus and benefits 1.6 lakhs. Being a member of the defined pension plan he won’t be getting the whole salary because some percentage of the amount needs to be paid as pension money, based on the calculation that an organization follows.
a) Career-average Pension Plans: A career-average defined benefit pension scheme is a vocational or employee pension scheme, where the amount is a total of their average earnings over their employment period but the amount of the benefit depends upon on the number of years of credited service. The employee earns a pension unit during each year of employment, which is usually expressed as a percentage (say 1.5% or 2%) of his or her income for that year. An employee usually gets a hike in their salary year by year in term of promotion, so the final amount is expressed as the portion of average earnings and from how long he or she is a pension plan holder. In a career average defined benefit pension scheme, it’s not easy to calculate how this pension scheme going to cost and how much will get at the time of retirement. Though all the benefits are fixed and adjusted from year to year to make sure the final amount will accumulate retirement planning.
Example: Defined benefit pension = 1/60th of career average
After 40 years of contribution = 40/60ths (2/3rds) average revalued earnings
Annual income = $30,000
Year of service = 30
Defined benefit pension benefit = $30,000 * 1.5% * 30
= $13,500 per year
b) Final and Best-earnings Pension Plans: Final and best-earnings plans are also unit-based plans, where the pension amount is entitled on the basis of average earnings in the last three to five years before retirement. In final-earnings plans, the unit percentage is applied to the years immediately preceding retirement. This could be the final three years of service or an earlier period of service when the employee’s best earnings were achieved. However, it is important to know that there is no guaranteed amount in a defined benefit, as in some cases the pension holder is not having sufficient amount to pay or in a position to meet the shortfall to have secure retirement pension. The pension amount is based upon the plan holder’s average income over the final X no. of years of his or her employment.
Example: Average annual salary for the last five years = $40,000
Year of service = 20
Retirement benefit = $40,000 * 2% * 20
= $16,000 per year
c ) Flat-benefit Pension Plans: In a defined benefit plan that uses a flat benefit formula, the benefit comes from multiplying the employee’s a minimum number of years of service by a predetermined flat rate. In other words, the pension plan where employee’s past years or months of service are calculated, which offers a set payout amount upon retirement. A unit benefit formula takes into account both the months or years of service as well as the income. There are different ways of Flat-Benefit Pension Plan to calculate the pension benefit, one where the calculation based on a percentage of wages earned throughout the service, and other two referred to as unit benefit and variable benefit. At the time of retirement, the employer will typically calculate the benefit by multiplying the months or years of service, their final average earnings over a set period of time, and a predetermined percentage. It does not differentiate the earning levels of plan participants, so these are suitable for those companies whose employees are earning approximately the same. Formula:
Years * average earnings * compensation percentage = annual retirement benefit
For the above example, the calculation yields: 35 * 120,000 *.02 = $84,000