In a defined benefit pension plan, an employer commits to paying its employee a specific benefit for life beginning at his or her retirement. The amount of the benefit is known in advance, and is usually based on factors such as age, earnings, and years of service. Defined benefit plans do not have contribution limits, but they do have a limit on the maximum annual retirement benefit.
for a chart of the annual limits on retirement benefits.
The employer is responsible for making the decisions about how much money to contribute and how to invest it. Employer contributions to the defined benefit plan are based on a benefit formula that calculates the investments needed to meet the defined benefit. These contributions are actuarially determined. Actuaries use statistical analysis to calculate the cost of future risks. The calculation takes into consideration the employee's life expectancy and normal retirement age, possible changes to interest rates, annual retirement benefit amount, and the potential for employee turnover.
Employees are always entitled to the vested accrued benefit earned to date. If an employee leaves the company before retirement, the benefits earned so far are frozen and held in a trust for the employee until he or she reaches retirement age (as determined under the plan). The defined benefit plan must allow its vested employees to receive their benefits no later than the 60th day after the end of the plan year in which the latest of the following occurs:
- They reach age 65 or the normal retirement age specified in their plan.
- They've been in the plan for ten years.
- They leave their employer.
The plan cannot force them to receive their benefits before normal retirement age unless they have less than $5,000 vested in the plan. However, employees must begin to receive their benefits no later than April 1 following the last year of employment or age 70 1/2, whichever is later.
Defined benefit plans distribute their benefits through life annuities. In a life annuity, employees receive equal periodic benefit payments (monthly, quarterly, etc.) for the rest of their lives. If an employee is married, upon his or her death the surviving spouse can continue to receive distributions of at least 50 percent of the periodic payment amount (unless the spouse consents to the participant receiving a single life annuity). Some plans may also allow them to receive the entire benefit in one lump sum at retirement.
