Definition
The term defined benefits plan refers to a pension plan whereby an employer provides employees with a known stream of income payments after they retire. With a defined benefits plan, the employer assumes all of the risk associated with the performance of the investments in the company's pension fund.
Explanation
Companies will provide employees with a pension plan as part of a larger array of employment benefits. Pension plans are structured by companies to provide a periodic and reliable source of income when the employee reaches the plan's normal retirement age. Generally, pension plans fall into one of the following two categories: defined benefits plans and defined contribution plans.
A defined benefits plan is considered a true employer-sponsored retirement plan, since the contributions that go into the pension fund's investments are made by the employer. The retirement income benefits derived from these plans are based on a predetermined formula, which is typically computed using a combination of the employee's salary over time, years of service with the company, and age. Companies can have a variety of rules, typically a combination of age and service, to determine when an employee might be eligible to retire with a full pension. On a federal level, Social Security is an example of a defined benefits plan that features a cost-of-living adjustment (COLA).
Since employers are essentially guaranteeing a given level of income when an employee retires, they must periodically adjust their contributions to ensure the pension's funds are adequate to provide this income. These calculations can be quite complex, since funding requirements are a function of employee age, length of service, turnover, compensation, life expectancies, and investment performance. For this reason, companies usually rely on an actuarial service to determine if a defined benefits plan is over or under funded.
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