In a defined benefit plan, the plan formula defines the benefit that will be paid at retirement age (or earlier separation from employment). An actuary determines the amount that must be deposited into the plan on an annual basis to provide the benefits called for under the terms of the plan.
In addition to the benefits to be paid, the actuary takes into account an expected rate of return and other factors (e.g., mortality) when determining the required contribution each year. In an active plan, the investment results do not alter the benefit the employee receives, as the benefit the employee receives is determined solely by the benefit stated in the plan document. However, actual investment results can cause the required contribution to decrease or increase from year to year based on whether they exceed or fall short of the actuary’s assumed returns.
The promised benefit must be provided to all participants regardless of the actual investment performance of the plan. Poor investment performance could result in increased contribution requirements. Because the employer is liable for providing the benefit, regardless of investment earnings, all investment risk is borne solely by the employer.
An advantage to adopting a defined benefit plan is that the annual contribution for business owners can be substantially higher in a defined benefit plan than in other types of retirement plans. Additionally, defined benefit plans tend to favor older, higher-paid employees.
There are two main types of defined benefit plans: