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Defined Benefit Plan Explained

Defined Benefit Plan Definition

This is the most common retirement plan sponsored by employers. In this plan, the employee benefits are defined by their employment tenure, salary record, and age. It is not directly dependent on individual investment returns. The employer is responsible for managing the portfolio and all the investment risks. There are strict rules regarding the withdrawal of this fund.

A Little More on What is a Defined-Benefit Plan

This plan is named defined benefit plan because both the employer and the employee know the computing formula for this benefit plan, in advance. The employer sets aside a specific amount of money regularly in a separate tax-deferred account for all the employees qualified to get this benefit.

As opposed to the pension funds, here the payment amounts do not depend on investment return. As it is the responsibility of the employer to manage the plan’s investment and take all the decision, the risk management is also done by them. Whereas, in the case of the pension fund the employer needs to assume the responsibility of poor returns resulting in funding deficit and it is their obligation to compensate the gap.

Under the defined benefit plan, on the retirement, the employee receives a specific benefit or payout. There are different payment options attached to this plan. It can be a fixed monthly payment until death, that is called single-life annuity. A plan can also provide qualified joint and survivor annuity which means a specific pay until death and thereafter a specific benefit for the surviving spouse.

Working extra years after the age of retire naturally increases the benefit amount as the amount depends on the service tenure and the final salary drawn.

This plan is also called defined benefit pension plan and the formula for computing the amount is known as the career average benefit formula, career average formula or career earnings formula.

References for Defined Benefit Plans

Academic Research on Defined Benefit Plan

Defined benefit versus defined contribution pension plans: What are the real trade-offs? Bodie, Z., Marcus, A. J., & Merton, R. C. (1988). In Pensions in the US Economy (pp. 139-162). University of Chicago Press. According to this paper, the defined contribution and the defined benefit were studied and they were said to have significantly different properties. The advantages of the DC plans were also studied as the most obvious during the period of inflation uncertainty. In this paper, quantifying the present value of accruing helped to define the benefits as being difficult at its best and has in a way imposed severe some vital information requirements on the workers.

The impact of taxes on corporate defined benefit plan asset allocation, Frank, M. M. (2002). Journal of Accounting Research40(4), 1163-1190. According to this paper, investigations were carried out to study the rate at which taxes have in the way or the other affect a corporation’s decision as to how the allocation of the benefit plan’s assets between bond and equity should be made. Earlier research indicates that if a firm integrates its financial plans as well as its pension investment policy, a difference in the tax rate will automatically create an arbitrage opportunity. This paper, however, finds corporations’ tax benefit as being significantly and positively associated with the rate of their pension assets spent on bonds.

Incentives and disincentives for financial disclosure: Voluntary disclosure of defined benefit pension plan information by Canadian firms, Scott, T. W. (1994). Accounting Review, 26-43. In this study, an empirical setback was addressed by carrying out further research which tests the hypotheses that were developed from the two disclosure theories. According to the research that was carried out, the Canadian firms’ voluntary disclosure of the defined benefit pension plan information was set as a case study. This paper, however, shows the principal cost implication and the relevance of the valuation of pension disclosures and then develop an empirical surrogate and several hypotheses for the private information acquisition cost savings and the propriety costs in this setting.

Optimal funding and asset allocation rules for definedbenefit pension plans, Harrison, J. M., & Sharpe, W. (1982). According to this research paper, a world in which pension funds defaults, no differential tax effects and the associated risk of default are not fully borne by the corporation was analyzed. Although, the main focus of this paper remains on the manner in which the riches of the shareholders of a firm sponsoring a pension plan might be influenced (increased) inasmuch as the Internal Revenue Service (IRS) and the Pension Benefit Guaranty Corporation (PBGC) abide by the simple and naïve policies that have been laid down.

Defined contribution plans, defined benefit plans, and the accumulation of retirement wealth, Poterba, J., Rauh, J., Venti, S., & Wise, D. (2007). Journal of public economics91(10), 2062-2086. This paper considered the private pension structure in the United States. According to this paper, once this structure has been dominated by the defined benefit plans, it becomes shared between the benefit plans and the defined contribution plans. The analysis carried out in this paper considered several possible asset allocation tactics with their asset returns gotten from the historical return distribution. Note that the simulation yield distribution of both the DB and the DC wealth at the retirement and the estimation of the certainty-equivalent wealth associated with the representative DC and DB pension structures were also explained in this paper. The result, however, suggests that on average, the retirement wealth accrual under the current DC plan is higher.

The valuation of reported pension measures for firms sponsoring defined benefit plans, Daley, L. A. (1984). Accounting Review, 177-198. In this paper, the three main measures in which the pension costs have historically been included in the most financial statement was listed and explained. Hence, the Financial Accounting Standards Board is currently putting in place, reporting standards for particular defined benefit pension plans. However, most investors are not limited to the accounting information in setting up their expectations for future pension costs. This paper then adopts the use of a cross-sectional equity valuation model which helps to access the rate of consistency of these three aforementioned accounting measures with the pension cost that can be used to estimates impound by the equity market accomplice in aggregate security prices.

Determinants of funding strategies and actuarial choices for definedbenefit pension plans, Asthana, S. (1999). Contemporary Accounting Research16(1), 39-74. In this study, the effects of the pension profiles and the firm’s financial funding actuarial choices and strategies were studied and examined. However, this paper uses the report recorded by individual pension plans and that of the Department of Labor under the requirements of the Employee Retirement Income Security Act of 1974 for the analysis. According to the result of this report, evidences which shows that as the firm becomes loaded with funds, they begin to make conventional actuarial choices which help to avoid the visibility costs hence, reducing the funding of the firm and make a liberal actuarial choice in other t avoid the visibility costs.

Corporate taxes and defined benefit pension plans, Thomas, J. K. (1988). Journal of Accounting and Economics10(3), 199-237. This paper studies examine and suggest several modifications to the Tepper-Black arguments for several tax-arbitrage chances from overfunding pension plans. The tax status is hence defined as a function of the expected future taxable income and the current marginal tax rates which are predicted as a determinant of the funding policy. The modified tax benefit view suggests that a decrease in the tax status is associated with the pension contribution reductions. Also, the cross-sectional tax status as defined in this paper is related to the choice of the actuarial variables, the fund levels and the use of the defined benefit plans.

Who owns the assets in a definedbenefit pension plan?, Bulow, J. I., & Scholes, M. S. (1983). In Financial aspects of the United States pension system (pp. 17-36). University of Chicago Press. In this paper, the liability to most employees in a well-defined benefit pension plan is described as the present value of the vested benefits, the current present value of the benefits that several employees would receive on the pressing termination of the pension plan. This is defined as the simple and literal definition of a liability. These irregularities, however, can be described by necessitating that employees as a group have specific human capital. A model was introduced in this paper and this model explains the irregularities as a natural outcome of the transactions of the members within the group.

The costs of defined benefit pension plans and firm adjustments, Barnow, B. S., & Ehrenberg, R. G. (1979). The quarterly journal of economics, 523-540. According to this research paper, the costs of the defined benefit pension plans and the firm adjustment was studied and the correlation between them was also explained.

Pension plan accounting estimates and the freezing of defined benefit pension plans, Comprix, J., & Muller III, K. A. (2011). Journal of Accounting and Economics51(1-2), 115-133. This paper gives evidence which suggests that when freezing the defined benefit pension plans, employers begin to select a downwardly biased accounting assumption which in the way or the other over-exaggerates the economic stress of their benefit plans. The downwards biased expected rates however return and the discount rates then allow managers to increase reported pension expenses and because of the discount rates, it also allows managers to increase reported pension liabilities. The findings in this paper are consistent with firm managers becoming opportunistically biased with pension estimates in other to get labour concessions during the time of the reduced regulatory scrutiny.

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