Defined benefit plan

What is a defined benefit plan?

A defined benefit plan is a retirement plan in which an employer promises to pay employees a fixed amount of money after they retire. The final amount is typically based on the length of their service to the organization and their salary.

Who contributes to a defined benefit plan?

In a defined benefit plan, the contribution is made primarily by the employer. In some rare cases, employees may also contribute. The employer typically invests the funds in regulated and relatively safe options such as pension funds, government bonds, debt mutual funds, or gratuity trusts so the money can grow steadily and support future payouts. Even if the investments don’t generate the expected returns, the employer is still responsible for paying the promised benefit, regardless of performance.

What is the formula to calculate a defined benefit plan?

There's no one universally accepted method to calculate a defined benefit plan. But, most of the employers use a fixed percentage, total years the employee has worked, and the average of the last few months' salary to calculate the defined benefit plan.

Defined benefit plan = Benefit percentage * Years of Servcie * Average salary

For instance, if an employee has worked for 25 years and their final salary is ₹50,000, and the employer sets a benefit percentage of 2%, the calculation would be: 2% × 25 years = 50%. This means the employee would receive 50% of ₹50,000, which is ₹25,000 per month after retirement.

What is the difference between a defined benefit plan and a defined contribution plan?

In a defined benefit plan, the final retirement payout is fixed in advance through a formula and is guaranteed by the employer. It does not depend on investment performance. In contrast, in a defined contribution plan, only the contribution amount is fixed. Employees and sometimes even employers contribute a percentage of salary toward the retirement corpus, and the final payout depends on how the investments perform.

What are some examples of defined benefit plans?

In India, gratuity is one of the classic examples of a defined benefit plan. The employer guarantees the final payout, and the gratuity amount is usually calculated using a pre-determined formula based on the years of service and average salary. In short, any benefit scheme that promises a fixed payout determined by a formula and is fully borne by the employer is considered a defined benefit plan.

What are the disadvantages of a defined benefit plan for employers?

Here are some disadvantages that HR teams should look out for while adopting a defined benefit plan:

Forces employers to bear any additional costs if their contributions and investments underperform
Creates long-term liability for the employers
Offers no room for flexibility as the promised amount has to be paid no matter what
Expects organizations to ensure compliance with strict regulatory compliance and disclosure norms
Remains volatile since the contribution costs can vary based on interest rate, inflation, and salary growth