Investment Updates
This Is Not Granddad's 'Defined Benefit Plan'
Published Monday, December 10, 2012 at: 7:00 AM EST
One type of retirement plan that was popular in your grandfather’s day, or maybe your father’s day, is making a comeback. It’s a “defined benefit plan” such as a traditional pension plan. Why the revival now? With a defined benefit plan, you can generally build a retirement nest egg faster than you can with a 401(k) or other kind of “defined contribution plan.” For this reason, defined benefit plans often appeal to older business owners or managers who are in a position to call the shots. But the plan does come with some potential drawbacks.
Basic premise: A defined contribution plan specifies an annual amount to be contributed on behalf of each participating employee. In contrast, a defined benefit plan specifies the amount of the benefits that will be paid to plan participants when they retire. It allows for large contributions over a relatively short period of time.
How is the amount of benefits determined in a defined benefit plan? Several methods may be used, but the specified benefit is generally predetermined by a formula based on an employee’s earnings history, length of service, and age. Commonly, the formula reflects that worker’s final salary. Under this formula, benefits are based on a percentage of average earnings during a specified number of years at the end of the employee’s career.
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