A defined benefit pension plan is a retirement plan in which the employer commits to paying a specified monthly payment to each eligible employee when he or she retires at a stated age. The monthly benefit is often based on a formula such as a percentage for each year of employment times the employee’s average monthly salary or wages during a three-year period prior to retirement. A hypothetical calculation for an employee retiring at age 65 might be 1% X 30 years of service X $4,000 per month average salary = $1,200 per month pension check.
Under the defined benefit pension plan, the employer commits to depositing enough money into a pension fund in order to cover the future benefits. Since there is uncertainty in the investment returns, the life expectancy of retirees, and other factors, the employer’s ongoing contributions, pensions expense, and net income are uncertain. This risk has resulted in the decline of defined benefit pension plans and has increased the popularity of defined contribution pension plans.
