Traditionally, many governmental and public entities, as well as a large number of corporations, provide defined benefit plans, sometimes as a means of compensating workers in lieu of increased pay.
Under this formula, benefits are based on a percentage of average earnings during a specified number of years at the end of a worker's career.
In a life annuity, employees receive equal periodic benefit payments (monthly, quarterly, etc.)
A defined benefit pension plan allows joint distributions so a surviving spouse can still receive 50 percent of your payment.
[8] Federal public sector plans are governed by the Internal Revenue Code and Federal law, while state and local public sector plans are governed by the Internal Revenue Code and state law.
Thus the funding requirements, benefits, plan solvency, and participant rights and obligations vary significantly.
Private sector plans are governed by the Employee Retirement Income Security Act of 1974 (ERISA).
Rooted in the principles of trust law, Title I of ERISA governs the fiduciary conduct and reporting requirements of private sector employee benefits plans through a system of exclusively Federal rights and remedies.
Title I is administered by the Employee Benefits Security Administration (EBSA) at the United States Department of Labor.
In FAP plans, the average salary over the final years of an employee's career determines the benefit amount.
This effect can be mitigated by providing annual increases to the pension at the rate of inflation (usually capped, for instance at 5% in any given year).
If the pension plan allows for early retirement, payments are often reduced to recognize that the retirees will receive the payouts for longer periods of time.
[13] In the US, ERISA explicitly forbids pay as you go for private sector, qualified, defined benefit plans.
This is because the dependency ratio or the number of people in retirement age over the size of the current working population is constantly growing and therefore the balance of contributions and benefits is broken resulting in deficits that need to be financed from government budget or addressed by increasing the contribution size.
The ageing related problems are actually not just a matter of specific demography, it has been suggested that each PAYG system passes through three stages – the young, the expanding and the mature.
The system is in surplus, which allows government to increase the size of old age pensions, providing much bigger return to their contributions then they would receive on the market.
Members of the founding generation start to retire and the number of contributors to pensioners drops to about eight to fourteen.
This stage sees greater expansion of the system introducing it also to lower income groups, while still keeping the benefits high.
Typically, the contributions to be paid are regularly reviewed in a valuation of the plan's assets and liabilities, carried out by an actuary to ensure that the pension fund will meet future payment obligations.
This "underfunding" dilemma can be faced by any type of defined benefit plan, private or public, but it is most acute in governmental and other public plans where political pressures and less rigorous accounting standards can result in inadequate contributions to fund commitments to employees and retirees.
[1] Traditional defined benefit plan designs (because of their typically flat accrual rate and the decreasing time for interest discounting as people get closer to retirement age) tend to exhibit a J-shaped accrual pattern of benefits, where the present value of benefits grows quite slowly early in an employee's career and accelerates significantly in mid-career: in other words it costs more to fund the pension for older employees than for younger ones (an "age bias").
Most plans, however, pay their benefits as an annuity, so retirees do not bear the risk of low investment returns on contributions or of outliving their retirement income.
The risks to the employer can sometimes be mitigated by discretionary elements in the benefit structure, for instance in the rate of increase granted on accrued pensions, both before and after retirement.
The age bias, reduced portability and open ended risk make defined benefit plans better suited to large employers with less mobile workforces, such as the public sector (which has open-ended support from taxpayers).
However, even with the best of tools, the cost of a defined benefit plan will always be an estimate based on economic and financial assumptions.
Many countries offer state-sponsored retirement benefits, beyond those provided by employers, which are funded by payroll or other taxes.
Individuals that have worked in the UK and have paid certain levels of national insurance deductions can expect an income from the state pension scheme after their normal retirement.
Individuals will qualify for the basic state pension if they have completed sufficient years contribution to their national insurance record.
Employers specify a contribution—usually based on a percentage of the employee's earnings—and a rate of interest on that contribution that will provide a predetermined amount at retirement, usually in the form of a lump sum.