How are benefits calculated in a defined benefit pension plan?
a. Based on the total contributions made by the employee
b. Based on the performance of the investment portfolio
c. Based on a formula considering factors like salary and years of service
d. Based on the employee’s age at retirement
The correct answer and explanation is:
The correct answer is c. Based on a formula considering factors like salary and years of service.
In a defined benefit pension plan, the retirement benefits are determined using a pre-established formula rather than being based on contributions or investment performance. The key factors used in the formula typically include the employee’s salary history, the number of years worked for the employer, and a fixed percentage or multiplier. The formula may look something like this:
Benefit = (Years of Service) × (Average Salary) × (Benefit Multiplier).
For example, if an employee worked for 30 years, had an average salary of $50,000, and the benefit multiplier was 2%, the annual pension benefit would be:
30 × $50,000 × 0.02 = $30,000 per year.
The benefit multiplier is usually specified in the plan and determines the proportion of the average salary that the employee will receive as a pension. The average salary is often calculated based on the highest-paid years of service, such as the last five years or the highest 3-year average salary.
The main advantage of a defined benefit plan is that it provides a predictable retirement income, often for life, which can be a significant benefit for employees seeking financial security in retirement. This predictability contrasts with defined contribution plans, where the retirement benefit depends on the contributions made by the employee (and employer) and the performance of the investment portfolio.
One thing to note is that defined benefit plans typically have specific vesting requirements, meaning that employees must work for a minimum number of years to be eligible for the pension benefits. If an employee leaves before meeting this threshold, they might forfeit the right to the pension benefits or receive a reduced amount.