Pension (defined-benefit plan)

Also called DB plan

An employer retirement plan that promises a set monthly income for life, usually based on salary and years of service.

What it means

A pension, or defined-benefit plan, pays retirees a predetermined benefit rather than depending on how an individual account performs. The employer funds the plan, invests the money and bears the investment risk. A typical formula multiplies years of service by a percentage and by the worker’s average salary near the end of their career.

Pensions have become rare in the private sector but remain common for government workers, teachers and some unionized jobs. Retirees may choose between a single-life payment and a smaller joint payment that continues to a surviving spouse, and some plans offer a lump sum. Many private pensions are insured by a federal agency up to limits; public pensions depend on their state or local government.

Formula

Annual benefit = Years of service × Benefit multiplier × Final average salary

Benefit multiplier = percentage set by the plan for each year worked
Final average salary = average pay over a period the plan defines, often the highest few years

Example

For example, a worker with 30 years of service under a formula of 1.5% times final average salary of $80,000 would receive 30 × 1.5% × $80,000 = $36,000 a year in retirement.

How it’s used

Public sector and union retirement planning
Comparing a lifetime payment with a lump sum
Estimating guaranteed retirement income

Strengths and weaknesses

Strengths

Predictable income for life
Employer bears the investment risk
Survivor options can protect a spouse

Weaknesses

Benefits are often small for people who change jobs often
Many pensions are not adjusted for inflation
Depends on the plan’s funding and the sponsor’s health
Less control and flexibility than an individual account

Educational information only, not financial, tax or legal advice. Rules, limits and rates change; check the IRS, your lender or plan, or a qualified professional before acting.