What is a Defined Benefit Pension?

With defined-benefit pensions, your employer promises you a specified benefit, usually in the form of monthly payments during retirement, and sets aside enough money to deliver on that promise. By contrast, with a defined-contribution plan, such as a 401(k) or 403(b), you fund your own retirement account through salary reductions, and your employer may (or may not) make additional matching contributions. Though defined benefit pensions aren't as common today, many Americans still have a traditional pension coming to them, either from their current job or a previous employer. If you’re among them, here are some of the things you need to know to get the benefits you deserve.

How Defined-Benefit Pensions Work

Top takeaway: Your employer will handle the investing decisions, but you’ll still want to pay attention to some key plan provisions, such as when the money actually becomes yours.

A defined-benefit plan is designed to provide you with a certain amount of income for retirement, based on such factors as your salary and length of service. Your employer generally makes all the contributions to the plan and decides how to invest them.

Employers can have both defined-benefit and defined-contribution plans, such as 401(k)s, at the same time. Defined-contribution plans don’t guarantee you a specific retirement benefit. How much money you’ll end up with in your account will depend on how much you and your employer have contributed to it and how well the investments you chose have performed over the years. In other words, the responsibility for successfully managing your retirement plan is shifted to you. There are also “hybrid” retirement plans that combine some of the features of both defined-benefit and defined-contribution plans, such as requiring both employer and employee contributions. These are most common among public sector employers, such as state governments.

A defined-benefit plan can be structured in a variety of ways and have a range of provisions, all of which should be spelled out in the Summary Plan Description (SPD) that your employer is required to give you when you sign up for the plan and periodically thereafter. You can also request a copy whenever you’d like, although you may have to pay a nominal fee for it. You should receive an individual benefit statement, showing the benefits you’re earned and their vesting status, at least once every three years. Your employer is also required to notify you if it makes any significant changes to the provisions of your plan.

One provision to pay particular attention to is vesting—that is, how soon the money your employer is setting aside for your account actually belongs to you. Some plans vest immediately, while others may do it gradually over a period of up to seven years. For example, you might become 20% vested after three years, 30% after four, and so on until you’re 100% vested in your plan after year seven. So if you’re contemplating a job change, it’s worth checking on your vesting status before you make any sudden moves.

If your employer decides to end, or “freeze,” its pension plan, you may become 100% vested immediately, although your benefits will be frozen at that point and not continue to grow in the future.

When Do You Get Money from Your Defined-Benefit Pension?

Top takeaway: Once you’re eligible for benefits you’ll face a big decision about which way to take them. Each has pros and cons.

You can generally start claiming benefits at age 65, or sooner if your plan sets an earlier retirement age. Your employer may offer you the choice of a one-time lump sum or a life annuity, which typically will pay you a fixed amount for the rest of your life, usually every month.

Lump Sum Benefits from Pension

If you take a lump sum, you can roll it over into an IRA and make withdrawals as needed. If you don’t roll it over into an IRA, you could face a whopping tax bill: regular income taxes on the whole amount plus a 10% tax penalty if you’re under age 59½. Your employer would also be required to withhold 20% of the payout to cover taxes.

As enticing as a big lump sum might seem, taking one is definitely not for everybody. It could make sense if you don’t have any other savings to speak of and would have trouble handling a financial emergency in retirement, such as a major home repair. It might also make sense if your health is poor and you aren’t likely to live long enough to receive much money in monthly annuity payments. On a more positive note, a lump sum could be a sensible choice if you’re sure you’ll have an adequate retirement income coming in from other sources.

Opting for a lump sum can also have some serious downsides. For one, you’ll be taking on the risk of investing and managing that money. Even if you’re a financial whiz, events beyond your control, such as a prolonged stock market slump, could take a severe toll on your account balance. And just because you’re a financial whiz at 65 doesn’t mean you’ll still be one at 85 or 95. You will also be giving up the major advantage of an annuity: reliable, regular income for the rest of your life, no matter how long you live. By taking a lump sum, you could run out of money if you withdraw too much or live longer than you ever expected.

Finally, if you roll your pension proceeds into an IRA, you will need to follow the IRS’s rules for taking required minimum distributions (RMDs) each year after you turn age 70½. If you take less than you are supposed to, you will owe a 50% tax penalty on the amount you failed to withdraw. You can find instructions on how to do the annual RMD calculation through the IRS. By taking regular annuity payments from your pension instead, you will generally be satisfying the distribution requirements automatically.

Getting an Annuity from Your Pension

One of the best advantages of taking out your money as an annuity is regular income. The annuity continues for the rest of your life, no matter how long you live. But annuities can have disadvantages, tool. One is that an annuity usually doesn’t leave you with anything to pass along to your children or other heirs. A lump sum might, assuming you don’t spend it all before you die.

What’s more, annuity payments in private-sector pensions are rarely indexed for inflation (government pensions are more likely to be). So your monthly benefit at age 80 could be the same as it was at age 65, even though inflation might have severely reduced its value in the intervening years. For example, even at a relatively modest inflation rate of 3% a year, $1,000 today would have the buying power of just $640 or so in 15 years.

Annuities also require some additional decisions. If you are married, you will have a choice of whether to take an annuity that simply covers your life, sometimes called straight-life annuity, or one that will continue to pay benefits to your spouse, should you die first. The latter arrangement, called a qualified joint and survivor annuity (QJSA), is the legal default option; if you want to take benefits just for yourself, your spouse will need to sign formal documents agreeing to that. With a QJSA, a surviving spouse will typically receive an amount equal to 50% or more of your individual benefit. To pay for that added coverage, your individual benefit will be reduced from what it would otherwise have been.

For example, suppose your pension benefit would be $2,000 a month with a straight-life annuity. You might only get $1,500 a month by electing to take a QJSA, but if you were to die first, your surviving spouse could continue to receive 50% of that, or $750 a month, for the rest of her or his life.

So, much of your decision will depend on what other assets or retirement income your spouse is likely to have. If your spouse would find it difficult to make ends meet without income from your pension, you will probably want to opt for some version of a QJSA. If, however, your spouse has other income sources, such as his or her own defined benefit pension, the two of you might decide differently.

If you leave the company before you reach retirement age, you may be required to keep the account there until you are ready to claim benefits. If that’s the case, remember to notify your ex-employer whenever your address changes and make sure your family knows about the existence of the account, just in case.

Private Annuities: Note that you could also take a lump sum and use it to buy an individual annuity from a private insurer. However, that’s often a losing proposition because you’re likely to get less income than you would by remaining with your employer’s group plan. In a 2015 report, the U.S. Government Accountability Office estimated that a 65-year-old man would receive a benefit that was about 17% lower with a private annuity than with an employer plan, while a 65-year-old woman would see a reduction in her benefit of about 24%.

Other Pension Resources

Finally, if you file a claim for benefits and don’t believe your employer is calculating them correctly, you have a right to appeal under the law. To learn more about your rights, visit a local office or the website of the Employee Benefits Security Administration, the division of the U.S. Department of Labor that oversees defined-benefit plans.

If you have questions or need assistance, the federal Consumer Financial Protection Bureau suggests consulting a nonprofit or federally funded pension counselor at PensionHelp.org. You might also speak with a fee-only financial planner, the kind who’s paid just for advice and doesn’t stand to earn a commission from selling you a particular product.

What Happens If Your Employer Goes out of Business?

Top takeaway: Your pension is probably safe even if your job isn’t.

If your employer goes bankrupt or has other serious financial difficulties, your pension may still be safe. For one thing, companies are required to keep their pension funds separate from other assets. The government also has rules for how much money companies must contribute to their plans each year to meet their future obligations.

In addition to those protections, your account may also be insured. Many private-sector employers’ pensions are insured by the Pension Benefit Guaranty Corporation (PBGC), a federal agency. The PBGC doesn’t cover federal, state, or local pension plans. Nor does it insure defined-contribution plans like 401(k)s. You can find out whether the PBGC currently insures your pension plan, and learn more about how your coverage works, on the agency’s website, pbgc.gov.

If your pension is covered, the PBGC will pay you the benefits you are entitled to, up to certain maximums, should your employer’s plan be unable to do so. The guaranteed maximums vary by the type of plan and by your age at the time the plan is terminated.

In 2017, for example, the PBGC guaranteed a maximum $5,369.32 benefit for a 65-year-old in a single-employer plan with a straight-life annuity. For someone of that age with a joint-and-survivor annuity designed to pay the survivor a 50% benefit, the maximum was $4,832.39. While that’s the highest amount the PBGC guarantees, the agency will, in some instances, pay more, based on such factors as how much money was in the plan. In practice, the PBGC says that most people end up getting their full pension benefit.

If you belong to a labor union, note that the PBGC has a separate program to insure multi-employer plans for certain union members. That program operates somewhat differently and calculates its maximum guaranteed benefits following a different formula from he one above.

Sources

IRS Required Minimum Distribution Worksheets

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