Defined-Benefit Plan

What Is a Defined-Benefit Plan?

A defined-benefit plan is a type of pension plan in which the employer promises to pay retirees a specific, predetermined amount. The benefit is usually calculated with a formula that considers factors such as length of service, age at retirement, and salary history. For example, a plan might pay a retiree 1.5% of their average final salary for each year worked. Because the promise is defined in advance, the employee knows roughly what income to expect in retirement.

How It Works

The employer funds the plan and is responsible for making sure there is enough money to cover future payments. Contributions are pooled into a trust and invested, often in a mix of equities and bonds. If investment returns are strong, the employer may need to contribute less. If returns are weak or the plan's obligations grow, the employer may need to contribute more. The investment risk and the longevity risk, meaning the risk that retirees live longer than expected, generally fall on the employer rather than the employee.

Many plans also track their funding status by comparing plan assets to the estimated present value of future benefits. This gap is often called the plan's funded status, and it can change significantly over time as markets move and interest rates shift.

Why It Matters to Investors

For individual investors, a defined-benefit plan is important mainly because it affects how much an employer is committed to pay in the future. Large unfunded obligations can be a financial risk for a company and may appear in its financial statements as liabilities. Investors reviewing a company often look at these pension obligations alongside its debt.

Defined-benefit plans are less common in the private sector than they once were, as many employers have shifted to defined-contribution plan arrangements such as 401(k)s, where the employee bears more of the investment risk. Public-sector employers, such as government agencies, still widely offer defined-benefit plans.