What is a Defined Benefit Plan : Features & How It Works

A Defined Benefit Plan is a pension scheme where the retirement benefit is clearly stated and fixed in advance. Employees know exactly how much they will receive after retirement, based on a set formula.

Unlike other retirement plans, where payouts depend on investment performance, the employer takes full responsibility for managing the fund and ensuring the promised amount is paid. If the investments underperform, the employer must make up the difference.

Below is an example of how a Defined Benefit Plan works:

Example: Ravi’s Pension Calculation

In this case, even if the market performs poorly, Ravi will continue to receive ₹25,000 per month after retirement. This offers a stable and predictable source of income for life.

In this blog, we will explore how defined benefit plans work, how to calculate pension by it and much more.

Understanding How a Defined Benefit Plan Works

A Defined Benefit Plan is an employer-sponsored pension scheme that guarantees a fixed income after retirement. The amount depends on:

• Salary history
• Age
• Years of service

It acts like a regular salary paid throughout retirement.

How does it work?

A defined benefit plan operates on a simple principle: the employee is promised a fixed pension, and the employer takes responsibility for making sure that promise is fulfilled. The way it works can be broken down into a few key points:

• Regular Contributions by the Employer
  The employer contributes money at regular intervals into a pension fund to build up the resources needed to pay future pensions.
   
• Investment Risk Managed by the Employer
  Unlike other schemes, the employee does not bear investment risks. The employer is responsible for ensuring that the fund performs well enough to cover promised payouts.
   
• Employee Contributions
  In some cases, employees may also be required or allowed to contribute a portion of their salary to the pension fund.
   
• Guaranteed Pension Payments
  Even if the investments underperform, the employer must step in and pay the promised pension amount, safeguarding the employee’s retirement income.

A defined benefit plan works by shifting the responsibility of saving and risk management onto the employer, offering employees a reliable and predictable income stream after retirement.

Why Do Employers Offer It?

Companies traditionally used these plans to:

• Encourage long-term employment
• Reward loyalty, the longer you stay, the more you earn at retirement

Read More – PPF vs NPS: Which is the Better Long-Term Investment?

Tax Advantages

Defined Benefit Plans follow IRS rules, offering key tax benefits:

• Tax-deferred growth of the pension fund
• Employer contributions are tax-deductible

How to Calculate Your Pension?

There are a few common ways companies calculate how much pension money you get each year after you retire. Each method uses your salary, the number of years you’ve worked, and a set percentage or amount.

Here are three easy formulas:

1. Career Average Earnings Formula

The company looks at how much money you earned every month across your whole career.

Formula:

(Defined% %) × (Average Monthly Earnings over Career) × (Years of Service)

Example:
If you earned ₹40,000/month on average, worked 30 years, and the defined % is 1.5%,

Your benefit = 1.5% × ₹40,000 × 30 = ₹18,000/year

2. Final Earnings Formula

The company uses your average monthly salary from the last 5 years before retirement.

Formula:

(Defined %) × (Average Monthly Earnings over Last 5 Years) × (Years of Service)

Example:
If your average salary in the last 5 years was ₹50,000, you worked 25 years, and the defined % is 1.8%,

Your benefit = 1.8% × ₹50,000 × 25 = ₹22,500/year

3. Flat Benefit Formula

The company gives you a fixed amount of money for each year you work.

Formula:

Defined Flat Amount × Years of Service

Example:
If the company gives ₹2,000 for each year worked, and you worked 20 years,

Your benefit = ₹2,000 × 20 = ₹40,000/year

Types of Defined Benefit Plans 

A Defined Benefit Plan is like a promise your employer makes to support you financially after retirement. Depending on the structure, this support can come as regular monthly payments or as a single lump sum. Broadly, there are two main types of defined benefit plans:

Here’s an easy comparison:
 

A Defined Benefit Plan may provide either a steady monthly income (pension plan) or a one-time payout (cash balance plan). In both cases, the employer carries the responsibility, ensuring employees receive their promised retirement benefits.

Also Read - EPFO’s New Interest Rate Decision: How It Impacts Your Retirement Savings

A Bit More About Each Plan

A Defined Benefit Plan is designed to give employees financial security after retirement, but the way the benefit is delivered can differ. Understanding the two common forms of a defined benefit plan helps employees know what to expect.

• Pension Plan (Monthly Payments)
  In this type of Defined Benefit Plan, the employee receives a fixed monthly payment after retirement, almost like pocket money from your job. However, you must stay with the employer long enough to be vested. Once vested, the pension is yours for life, even if you leave the company. This makes the pension plan the most traditional form of defined benefit plan.
   
• Cash Balance Plan (One Big Payment)
  A cash balance plan is another type of Defined Benefit Plan, but instead of monthly payments, it works like a piggy bank. The employer contributes money every year, which grows over time. When you retire or leave, you receive the accumulated sum as a lump-sum payment. Here too, the company carries the responsibility of managing the fund, but it does not promise lifelong monthly income.

Whether it is through a pension plan or a cash balance plan, a Defined Benefit Plan shifts the responsibility of funding and investment risk to the employer. For employees, this makes a defined benefit plan one of the most secure and predictable retirement options available.

Why a Defined Benefit Plan Is Helpful?

A Defined Benefit Plan is designed to provide employees with financial security once they retire, but the way the retirement benefit is delivered can vary. By understanding the two main forms of a defined benefit plan, employees can better plan for their future.

Let’s look at how this plan helps:
 

Whether it comes through a pension plan or a cash balance plan, a Defined Benefit Plan places the responsibility of funding and investment risk on the employer. For employees, this makes a defined benefit plan one of the most reliable and predictable retirement choices available.

What Is a Defined Contribution Plan?

Apart from a Defined Benefit Plan, where your employer promises to pay you a fixed amount after retirement, there is another type of retirement scheme known as a Defined Contribution Plan. This plan shifts the responsibility from the employer to the employee, making it more flexible but also more dependent on individual choices.

In a Defined Contribution Plan, you decide how much money to save from your salary each month. It’s a bit like putting pocket money into a special savings jar for your future. Many companies also add to this jar by matching your contributions—sometimes even doubling or tripling what you save.

Well-known examples include 401(k) and 403(b) plans in some countries. You contribute regularly, your employer may add more, and the invested money grows over time. However, here’s the catch: you are responsible for the outcome. The more you save and the better your investments perform, the more you will have after retirement.

These plans also come with rules about when and how much you can withdraw without paying extra tax, ensuring that the money is primarily used for retirement.

In summary, a Defined Contribution Plan offers flexibility and growth potential, but it also places the risk and responsibility on the employee. Unlike a defined benefit plan, the retirement income is not guaranteed it depends entirely on contributions and investment performance.

The plan also sets rules about when and how much you can take out of your savings without paying extra tax.

Conclusion

A Defined Benefit Plan gives you a steady income after retirement, based on your salary and how long you worked. The employer handles the investment risk and promises regular payments, helping you enjoy a stable and worry-free retirement.

FAQ’s

1. Do Defined Benefit Plans protect me from market ups and downs?

Yes, your pension stays the same regardless of how the stock market performs, since the employer carries the risk.

2. Can my pension from a Defined Benefit Plan increase over time?

Some plans offer cost-of-living adjustments (COLA), which means your pension may rise with inflation, but not all plans include this feature.

3. What if my employer’s company shuts down?

In many countries, regulators or pension protection funds step in to safeguard at least part of your benefits, though terms vary by law.

4. Can I pass on my Defined Benefit Plan to my spouse or family?

Yes, many plans allow survivor benefits, so your spouse or dependents may continue to receive payments after your death.

5. Is a Defined Benefit Plan flexible if I want early retirement?

It can be, but usually with reduced payments, since you’ll be drawing your pension for a longer period.
 

Apply for Loans Fast and Hassle-Free

Apply Now

About the Author

LoansJagat Team

We are a team of writers, editors, and proofreaders with 15+ years of experience in the finance field. We are your personal finance gurus! But, we will explain everything in simplified language. Our aim is to make personal and business finance easier for you. While we help you upgrade your financial knowledge, why don't you read some of our blogs?