It's no secret that Americans are having trouble saving for retirement, based on study after study.
According to one recent report from Northwestern Mutual, 21% of Americans have zero cash saved for retirement savings while another 10% have less than $5,000 saved up for their golden years.
Demographically, the segment of the population is struggling to save for retirement. The Northwestern Mutual study reports that one-third of Baby Boomers either in or approaching retirement have between zero and $25,000 set aside for their post-working years.
One way Americans can do a better job is maximizing their savings in employer-sponsored retirement plans - especially the defined benefit plan.
What Is a Defined Benefit Plan?
Defined benefit plans (also called company pension plans) are qualified retirement plans from employers that pays out a specified amount to employees once that employee reaches retirement age. The calculation used to determine the cash paid out to the retiring employee is based on a number of factors, including length of employment at the company, age (usually between 59-and-a-half to age 65), and average salary over a sustained period of time.
If the employee is forced to retire early, usually due to ill health or injury, that employee still receives benefits derived from the defined benefit planned. In the event of the worker's passing before retirement age, the company will pay out defined benefit plan contributions to the worker's spouse or next of kin.
Defined Benefit Plan vs. Defined Contribution Plan
Defined benefit plans are not the same as defined contribution plans, where the amount a career professional takes into retirement depends upon the amount of money the worker saved in a 401(k) or individual retirement plan sponsored by the company.
Primarily, the big difference between a defined benefit plan and a defined contribution plan is that the employer takes on the responsibility of funding the employee's retirement plan. With a defined contribution plan, it's the employee who takes the responsibility of funding a defined contribution plan.
In specific situations, like when an employer offers a 401(k) matching amount to a worker's defined contribution plan, employers can play a mixed role in helping employees meet their retirement planning needs.
That matters to both an employer and an employee.
With a defined benefit plan, the employer assumes the investment risk associated with the plan. If the investments chosen by the plan's investment advisor don't earn enough to pay the agreed upon amount to the worker upon retirement, the employer must make up the difference and fully fund the plan payout.
In a defined contribution plan, the reverse is true.
If an employee's 401(k) plan doesn't make investments that earn money for the worker, the employer is under no obligation to make up the difference and fund that employee's defined contribution plan.
Pros and Cons of a Defined Benefit Plan
Like any employer-based retirement plan, there are upsides and downsides that must be factored to get the most from the retirement plan.
Let's take a look at the bad and the good with defined contribution plans:
Benefits of Defined Benefit Plans
Straightforward payments. There's no big mystery on how defined benefit plans pay retirement workers. Defined benefit plans are paid out very much like an annuity, either in a lump sum payment or via regular payments, in a regular income stream. It's up to income-minded retirees to decide how they wish to get paid, although an employer may have a say in the matter, too.
Guaranteed lifetime income to retirees. There's also no mystery on the total payment income with defined benefits plans. They're structured so that all the money is on the table and no retiree will outlive a plan payment annuity.
Not covered by Social Security? Defined benefits have your back. Many governmental government workers don't pay into Social Security. For those workers, a defined benefit plan is arguably a better replacement that provides solid financial security in retirement.
Inflation protection a big help. Defined benefit plans automatically rise in value relative to inflation during a worker's years on the job, thus providing ideal protection against inflation eating away at their retirement savings.
Fees are lower. Defined contribution plans usually come with investment management fees that are lower than fees tied to defined contribution plans.
Downsides to Defined Benefit Plans
Job to job flexibility is problematic. By and large, defined benefit plans aren't created with job transition portability as a priority. Instead, defined benefit plans are designed to reward workers who stay on the job with the same company or organization for years. There is some portability protection for workers, thanks to new federal statutes, but defined contribution plans are much easier to move from job to job than defined contribution plans.
Transparency an issue. It's not the fault of the employer, as defined benefit plan benefits by design, are difficult to track. Yet since it's the employer who's funding the account and not the employee, (as with a 401[k] plan) getting a good grip on how the plan is performing, and how much an employer is actually contributing to the plan can be a problem. A good investment advisor can help clear any confusion about plan assets and how they're accumulating.
You can't choose your own investments. Unlike a defined contribution plan, where an employee can choose his or her own plan investments with the help of an investment advisor, defined benefit plan investments aren't chosen by the employee. Instead, the employer drives the investment selection process. That could wind up costing you money, as you - with the assistance of a financial specialist - may do a better job of selecting higher-returning plan investments.
You have to work a certain number of years. Employees who enroll in defined benefit plans must work a minimum number of years before they qualify for plan benefits. This feature, known as "vesting," protects the employer from paying out on a defined benefit plan to employees who leave the job early. So-called "phase-in" features enable companies to gradually qualify you for specific plan benefits on a gradual basis, with full vesting coming after a specific set of years on the job.
What Is a Cash Balance Plan?
Increasingly, employers are starting to offer retirement plans that blend the best elements of a defined benefit plan and defined contribution plan.
These retirement accounts, called "hybrid" retirement plans or "cash balance" plans, pay workers a specified amount of money after they leave the workforce, just like a defined benefit plan.
But there's a wrinkle with cash balance plans that come from the defined contribution-plan model. In these hybrid plans, companies can offer retirement funds that grow in an individual retirement account, just like in a 401(k) plan.
Among other benefits, having access to an individual retirement account in the employee's name, while still being guaranteed a retirement payout, gives that employee the best of both worlds.
He or she can more easily track fund accumulation amounts, and can also take the plan if they leave for a new job or opt for a lump-sum payout, which the employee can turn around and invest in his or her new company's retirement plan, through an IRA rollover.
If you wind up transitioning from a defined benefit plan to a hybrid cash balance retirement plan, tax issues can apply. Thus it's a good idea to consult with a professional accountant or tax specialist before signing on the dotted line.
The Takeaway on Defined Benefit Plans
While your company will do the heavy lifting, defined benefit plan recipients owe it to themselves to review their plan thoroughly.
Special focus should be on the amount of money you can expect to earn from your employer when you retire, a number your employer should provide you with on an annual basis.
Consequently, ask for help if you don't know to find this information and consider bringing a financial planner aboard to review your defined benefit plan documents, especially with a close look at the plan's fine print. If, for example, you wish to retire early or leave your job, you'll want to know exactly how those moves will impact your plan payout, one way or another.
Past that, just keep doing your job and watch your defined benefit plan proceeds accrue. One day, it should all result in a tidy nest egg for a comfortable retirement.