Defined Benefit Plan
A defined benefit plan is an employer-sponsored retirement plan that promises employees a specified monthly benefit at retirement, typically calculated using a formula based on salary history and years of service.
Defined benefit plans — commonly called traditional pensions — place the investment risk and funding obligation on the employer rather than the employee. The sponsoring employer contributes to a trust, invests those assets, and guarantees that plan participants will receive a predetermined retirement income regardless of how the underlying investments perform. If the trust fund earns less than projected, the employer is responsible for making up the shortfall.
The benefit formula most commonly used multiplies three variables: the employee's years of credited service, a benefit accrual rate (often 1% to 2% per year), and either final average salary or career average salary. For example, a plan with a 1.5% accrual rate would provide an employee with 30 years of service a monthly benefit equal to 45% of their average final salary. Many plans also apply an early retirement reduction factor if the employee retires before the plan's normal retirement age.
Defined benefit plans are governed by the Employee Retirement Income Security Act of 1974 (ERISA), which establishes minimum participation, vesting, and funding standards. Private-sector defined benefit plans must also pay insurance premiums to the Pension Benefit Guaranty Corporation (PBGC), a federal agency that insures benefits up to statutory limits if a plan sponsor goes bankrupt and the plan terminates with insufficient assets.
The Internal Revenue Code imposes limits on the annual benefit that can be paid from a tax-qualified defined benefit plan. Under IRC Section 415, the maximum annual benefit is the lesser of 100% of the participant's average compensation for the three highest consecutive calendar years or a dollar limit adjusted annually by the IRS (set at $275,000 for 2024). Contributions to the trust are tax-deductible for the employer, earnings within the trust grow tax-deferred, and benefits are taxed as ordinary income when received by the participant.
Defined benefit plans have declined sharply in the private sector over the past four decades. Many corporations have frozen existing plans — stopping future benefit accruals — and shifted to defined contribution plans such as 401(k)s to reduce balance sheet liabilities and funding volatility. They remain prevalent in state and local government employment, where a large portion of the public workforce still participates in traditional pension arrangements. The funding status of these public pension systems, measured by the ratio of assets to projected benefit obligations, is closely watched by credit rating agencies and policymakers.