What Are the Pros and Cons of a Defined Benefit Plan?

Defined benefit plans, often referred to as traditional pensions, offer a reliable stream of income in retirement. These plans can provide peace of mind with guaranteed income, but they also tend to be less flexible than defined contribution plans like 401(k)s. They are also not available to most private-sector workers. Whether you’re evaluating a job offer or reviewing your retirement benefits, weighing the benefits of a defined benefit plan against the potential drawbacks can help you make more informed investment decisions.

A financial advisor can help you assess how a defined benefit plan would work alongside your other retirement assets and strategies.

What Is a Defined Benefit Plan?

A defined benefit plan is a type of employer-sponsored retirement plan that guarantees a specific payout upon retirement. Unlike defined contribution plans, such as 401(k)s, where the retirement benefit depends on investment performance, defined benefit plans promise a fixed income based on a predetermined formula. This formula typically considers factors like salary history, years of service and age at retirement.

The plans are funded primarily by the employer. However, in some cases, employees may be allowed or required to contribute as well. The employer assumes the investment risk and is responsible for ensuring there are sufficient funds to pay the promised benefits. Payments are usually made as monthly annuities for life, though some plans also offer lump-sum payout options.

Defined benefit plans are common in public sector employment but uncommon in private industry due to their cost. In March 2023, 15% of private-sector workers had access to a defined benefit plan, according to the Bureau of Labor Statistics. By comparison, 67% of these workers had employer-sponsored defined contribution plans.

Benefits of a Defined Benefit Plan

Defined benefit plans offer several significant advantages, particularly for individuals seeking long-term financial security in retirement. These plans provide predictability, reduce market risk for employees and are often structured to reward long tenure and loyalty.

Here are four primary benefits of a defined benefit plan.

Guaranteed Retirement Income

One of the biggest benefits of a defined benefit plan is that it offers a guaranteed income stream for life. This fixed payment removes much of the uncertainty surrounding how much income you’ll have in retirement. Unlike a 401(k), where the final value depends on how well your investments perform, a defined benefit plan ensures a predictable payout.

This can be especially valuable in volatile markets or economic downturns, when retirees relying on investment-based plans might see their account balances shrink. Knowing you’ll receive a consistent monthly check can bring peace of mind and simplify retirement planning.

Employer-Funded Contributions

In most defined benefit plans, the employer is solely responsible for funding the plan, which means employees are not required to contribute. Even if employee contributions are allowed or required, the bulk of the responsibility remains with the employer. This allows employees to accumulate retirement savings without reducing their take-home pay.

Tax Advantages

Defined benefit plans are tax-deferred, meaning the money you receive in retirement is taxed as regular income at the time of withdrawal, not when it’s earned. For employers, contributions are tax-deductible and plan assets grow tax-deferred until distributions begin. These tax benefits can be useful for high-income earners who expect to be in a lower tax bracket in retirement.

Incentive for Long-Term Employment

Defined benefit plans are often designed to reward long-term employment. The benefit formula usually favors employees who spend a significant number of years with the same employer, as years of service are a key factor in the retirement payout. This setup can lead to better retirement outcomes for employees who stay with one employer for most of their career.

Drawbacks of a Defined Benefit Plan

A man close to retirement calculating how much he needs to save.

Despite their many advantages, defined benefit plans also come with some limitations. These drawbacks often lead employers to favor defined contribution plans, and employees must carefully evaluate whether these issues might impact their overall financial planning. Here are three common drawbacks of a defined benefit plan.

Lack of Portability

One of the biggest downsides is that defined benefit plans are not portable. If you leave your employer before you’re vested or before reaching retirement age, you may lose some or all of your accrued benefit. Even if you’re vested, you may not receive the full projected value of the plan unless you remain with the company until retirement.

This can be a disadvantage in today’s job market, where people are more likely to change employers multiple times over the course of their career. In contrast, defined contribution plans like 401(k)s are portable and follow the employee, regardless of job changes.

Limited Control Over Investments

With a defined benefit plan, the employer manages the investments, not the employee. This can reduce stress and eliminate the need to actively manage a portfolio. However, it also means you have no say in how the funds are invested or how aggressively they grow.

For individuals who prefer to have more control over their retirement strategy, this lack of flexibility can be frustrating. If the plan is underfunded or poorly managed, there’s also the risk (albeit minimal in well-regulated plans) that expected benefits could be reduced or frozen.

Plan Funding Risk

Though this is primarily an employer concern, it’s worth noting that defined benefit plans are expensive to maintain. Employers must ensure the plan is sufficiently funded to meet future obligations, and if investment returns fall short or employee longevity increases, the costs can escalate.

This financial burden has led many private companies to freeze or terminate their defined benefit plans in favor of more predictable defined contribution plans. While the Pension Benefit Guaranty Corporation (PBGC) offers some protection, plan participants could still see reduced benefits if their employer defaults and the plan is severely underfunded.

Frequently Asked Questions

What Is the Difference Between a 401(k) and a Defined Benefit Plan?

The primary difference lies in how the retirement benefit is determined. A 401(k) is a defined contribution plan where the employee (and often the employer) contributes a specific amount, and the final account balance depends on investment performance. In contrast, a defined benefit plan promises a set monthly income in retirement, regardless of market conditions, and is funded primarily by the employer.

401(k) plans are portable, give the employee control over investments and require active contribution decisions. Defined benefit plans, on the other hand, are managed by the employer and offer predictable income, but are less flexible and tend to favor long-term employees.

What Are the Payout Options for a Defined Benefit Plan?

Most defined benefit plans offer several payout options upon retirement. The most common is a single life annuity, which provides a monthly payment for the rest of your life. There is also the joint and survivor annuity, which provides lifetime payments to both the retiree and their spouse, often at a reduced rate.

Some plans also allow for a lump-sum distribution, where you receive the present value of your pension in a single payment. This option provides flexibility and the potential for investment growth, but also transfers the responsibility for managing the funds and market risk to the retiree.

What Happens to My Defined Benefit Plan If I Leave My Job Early?

A retired couple enjoying their retirement savings.

If you leave your job before becoming vested, you typically forfeit any future benefits under the plan. Vesting schedules vary by employer, but often range from three to seven years. If you are vested, you retain your right to the benefit earned, but it may be frozen until you reach retirement age.

You won’t lose your benefit entirely, but you may need to wait until age 65, or whatever the plan’s designated retirement age is, to begin collecting payments. Always check your plan’s vesting schedule and payout rules before making career moves that could impact your retirement income.

Bottom Line

Defined benefit plans offer stability and guaranteed income in retirement, making them a valuable asset for employees who stay with an organization long-term. The benefits of a defined benefit plan — including predictable payments, employer funding and tax-deferred growth — can provide a solid financial foundation in retirement. However, limited portability and lack of investment control may make these plans less attractive for mobile workers or those seeking flexibility.

Tips for Retirement Planning

A financial advisor can help you determine when is the best time to retire. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
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