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What is a Defined Benefit Pension Plan?

Under a defined benefit pension plan, the contributions are actuarially determined based on the anticipated benefit a participant will receive at retirement. In other words, the first step in a defined benefit plan is to determine (define) the ultimate retirement benefit desired. This benefit, expressed in terms of a life annuity, cannot exceed the lesser of $150,000 (2004) per year or 100% of the average high three year compensation (indexed for inflation). Under a defined benefit pension plan, a participant knows from inception what their future retirement benefit will be. It is the company's contribution that in unknown from year to year. The company bears investment risk in that if the assets fail to earn the rate of return that was used in the actuarial assumptions, a greater contribution will be required the following year and possibly further years. Or, conversely, if the investments outperform expectations, the plan will have an actuarial gain which will reduce future contribution requirements. Defined benefit plans favor older participants, since large contributions may be made on their behalf, as they have less time to fund for that benefit. The advantage of a defined benefit plan is that the participant is not limited to 100% of annual compensation or $40,000 like a defined contribution plan.


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