Defined benefit
A defined benefit pension plan is a type of pension plan in which an employer/sponsor promises a specified pension payment, lump-sum (or combination thereof) on retirement that is predetermined by a formula based on the employee's earnings history, tenure of service and age, rather than depending directly on individual investment returns. Traditionally, many governmental and public entities, as well as a large number of corporations, provided defined benefit plans, sometimes as a means of compensating workers in lieu of increased pay. A defined benefit plan is 'defined' in the sense that the benefit formula is defined and known in advance. Conversely, for a "defined contribution retirement saving plan", the formula for computing the employer's and employee's contributions is defined and known in advance, but the benefit to be paid out is not known in advance. In the United States, specifies a defined benefit plan to be any pension plan that is not a defined contribution plan where a defined contribution plan is any plan with individual accounts. A traditional pension plan that defines a benefit for an employee upon that employee's retirement is a defined benefit plan.
The most common type of formula used is based on the employee's terminal earnings (final salary). Under this formula, benefits are based on a percentage of average earnings during a specified number of years at the end of a worker's career.
In the private sector, defined benefit plans are often funded exclusively by employer contributions. For very small companies with one owner and a handful of younger employees, the business owner generally receives a high percentage of the benefits. In the public sector, defined benefit plans usually require employee contributions.
Over time, these plans may face deficits or surpluses between the money currently in their plans and the total amount of their pension obligations. Contributions may be made by the employee, the employer, or both. In many defined benefit plans the employer bears the investment risk and can benefit from surpluses.
When participating in a defined benefit pension plan, an employer/sponsor promises to pay the employees/members a specific benefit for life beginning at retirement. The benefit is calculated in advance using a formula based on age, earnings, and years of service. In the United States, the maximum retirement benefit permitted in 2014 under a defined benefit plan is $210,000 (up from $205,000 in 2013). Defined benefit pension plans in the U.S. currently do not have contribution limits.
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