Nature of Define-Benefit Pension Plans

A defined-benefit pension plan is any plan that defines the amount of the pension benefit payable at retirement, usually by way of a formula that relates the value of the pension benefits to earning levels and years of service.

A defined-benefit pension plan differs dramatically from other types of pension plans because the benefit is defined up-front, but the amount of employer contributions typically is not. Employee contributions (if required), are usually set at a fixed percentage of employment earnings. The employer must then contribute sufficient additional money to ensure that the future pensions of plan members are adequately secured.

There are three basic forms of defined-benefit pension plans, as discussed below.

Career-Average Pension Plans

A career-average, defined-benefit pension plan relates the amount of pension benefit payable at retirement to average earnings during an employee's career, as well as the number of years of credited service. The employee earns a pension "unit" during each year of employment, which is usually expressed as percentage (say 1.5% or 2%) of his income for that year. His full pension at retirement will be the sum of all the units accrued while he was a member of the pension plan.

Final and Best-Earnings Pension Plans

Final and best-earnings plans are also unit-based plans, where the ultimate pension entitlement is related to a unit percentage for every year of credited service. In final-earnings plans, the unit percentage is applied to the final three to five years of service. In best-earnings plans, the unit percentage is applied to a figure no higher than the average of the best three (or five) years of pensionable service. This could be the final three years of service or an earlier period of service when the employee's best earnings were achieved.

Flat-Benefit Pension Plans

Retiring members of a flat-benefit pension plan receive a flat rate benefit, regardless of their earnings. However, the full benefit may only be available to those who have achieved a minimum level of service, such as 25 years, with a proportionally reduced pension available to those with lesser service.

The flat rate benefit may be expressed in different ways. Some plans offer a fixed amount per month, such as $500 per month, to retiring employees with the required level of service, and prorate that amount for employees with less service. Other plans provide a flat amount of pension per month, for every year of service.