Defined Benefit Plan Explained

August 8, 20235 min read
Defined Benefit Plan Explained
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Key Takeaways

  • A defined benefit plan (DBP) is an employer-sponsored plan wherein employee benefits are determined by a formula that uses a number of factors, including compensation history and length of employment.
  • By law, whether due to subpar investment returns or erroneous calculations or assumptions, employers must remedy any shortfall with a cash contribution.
  • Unlike defined contribution plans, which are more common, DBPs call for the employer, rather than the employee, to handle all the planning and investment risk.

A defined benefit plan (DBP) is an employer-sponsored plan wherein employee benefits are generally determined by a formula that uses a number of factors, including compensation history and length of employment.

The employer is tasked with plan management and risk, and typically hires an external manager for that.

By law, whether due to subpar investment returns or erroneous calculations or assumptions, employers must remedy any shortfall with a cash contribution.

What are Examples of Defined Benefit Plans?

Two prime examples of DBPs are pension and cash balance.

  1. Pension. Here, an employee must first become “vested” by staying with a company for a certain period, depending on the company. For example, someone with a year on the job may be 20% vested, which may grant them retirement payments that are equal to 20% of a full pension.
  2. Cash balance. Upon retirement or when they leave the company, employees in these plans get a sum based on their length of service. The cash balance is usually calculated based on pay credits and interest credits. Usually, an employee’s account is credited annually with a pay credit – 3% of compensation, for example – as well as an interest credit for what is in the account. Payment to the employee may be an annuity or lump sum.   

Rules of Defined Benefit Plan

Generally, defined benefit plans require annual employer contributions. The required amount is equal to the value of the year’s benefit increases in addition to a 15-year amortization of all unfunded liabilities. An overfunded plan means there is no amortization.

Defined Benefit Plan Options

Employees are usually unable to withdraw funds from their plan, as they could with a 401(k) plan. Instead, at an age “defined” by the plan’s rules, they can receive their benefit as a lifetime annuity. In some cases, the benefit can be taken as a lump sum.

Pros and Cons of DBP

As with most anything in the investment and finance space, there are benefits and drawbacks to defined benefit plans. 

Pros

  • Steady retirement income.
  • Payments unaffected by the performance of underlying investments.
  • Potential beneficiary support upon the employee’s death.
  • Employer tax deduction.
  • Better retention since employees wish to be vested.

Cons

  • No say in how employees’ money is invested.
  • Vesting takes time; five years is common.
  • Difficulty moving money from plan to plan as an employee switches jobs.
  • Pricey to maintain since payments are guaranteed regardless of market conditions.
  • No opportunity for employees to increase their benefit.

How Does DBP Differ from Defined Contribution?

Unlike defined contribution plans, which are more common, DBPs call for the employer, rather than the employee, to handle all the planning and investment risk.

Likewise, a DBP chiefly requires the employer to make contributions, whereas a defined contribution plan has employees make most contributions, although many companies provide some matching contributions.  

Also, unlike defined benefit plans, defined contribution plan payouts are not guaranteed, as they rely on investment performances and employee contributions.

Alternatives to Traditional Retirement Plans

Rather than a defined benefit plan, or in addition to one, individuals can save with after-tax accounts such as Roth IRAs or tax-deferred accounts like traditional IRAs. For this year, IRA savings can reach $6,500, or up to $7,500 if the person is at least 50. 

Another alternative to traditional retirement plans is investments in alternative assets, which are increasingly popular as investors seek respite from constant stock market fluctuations.

Because of their low correlation to public markets, alternatives are generally not as volatile, and can provide steady income during retirement, and protection from inflation. In fact, in every economic downturn of the last 15 years, private markets have outperformed stocks.

How to Add Alternatives to Your Portfolio

Also increasingly popular as a way to easily invest in alternatives is the platform Yieldstreet, on which nearly $4 billion has been invested to date. 

Focused on generating passive income for investors, Yieldstreet offers the broadest selection of alternative asset classes, including art, real estate, transportation, legal finance, private credit, and more. In addition to its highly vetted investment opportunities, Yieldstreet also has a free retirement calculator to help people calculate how much they will need for the Golden Years.

A crucial benefit of such investments is diversification – mixing a variety of asset types within a portfolio to reduce overall risk. In fact, diversifying one’s holdings is an essential pillar of long-term investing success.

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Portfolio Diversification and Alternative Investments

Alternative investments can be a good way to help accomplish this. Traditional portfolio asset allocation envisages a 60% public stock and 40% fixed income allocation. However, a more balanced 60/20/20 or 50/30/20 split, incorporating alternative assets, may make a portfolio less sensitive to public market short-term swings. 

Real estate, private equity, venture capital, digital assets, precious metals and collectibles are among the asset classes deemed “alternative investments.” Broadly speaking, such investments tend to be less connected to public equity, and thus offer potential for diversification. Of course, like traditional investments, it is important to remember that alternatives also entail a degree of risk. 

In some cases, this risk can be greater than that of traditional investments.

This is why these asset classes were traditionally accessible only to an exclusive base of wealthy individuals and institutional investors buying in at very high minimums — often between $500,000 and $1 million.  These people were considered to be more capable of weathering losses of that magnitude, should the investments underperform.

However, Yieldstreet has opened a number of carefully curated alternative investment strategies to all investors. While the risk is still there, the company offers help in capitalizing on areas such as real estate, legal finance, art finance and structured notes — as well as a wide range of other unique alternative investments. 

Moreover, investors can get started with a relatively small amount of capital. Yieldstreet has opportunities across a broad range of asset classes, offering a variety of yields and durations, with minimum investments as low as $10,000.

Learn more about the ways Yieldstreet can help diversify and grow portfolios.

In Summary

With a defined benefit plan, an employee is guaranteed a specific benefit when they retire. Such plans can be beneficial to both the employee and employer.

Remember, too, that options for investing in one’s retirement can include alternatives, which also serve the vital purpose of portfolio diversification.  

We believe our 10 alternative asset classes, track record across 470+ investments, third party reviews, and history of innovation makes Yieldstreet “The leading platform for private market investing,” as compared to other private market investment platforms.

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