Unit Benefit Formula

Key takeaways

• The unit benefit formula calculates pension benefits as a percentage of salary for each year of service.
• Typical benefit percentages range from about 1.25% to 2.5% per year of service.
• The formula rewards long service but can be costly for employers because it requires actuarial valuation and the employer bears investment risk.

What the unit benefit formula is

The unit benefit formula is a method used in employer-sponsored pension plans (defined benefit plans) to determine an employee’s retirement benefit. It expresses the annual pension as:

Benefit = Years of service × Benefit percentage per year × Salary measure

The salary measure is often the career average salary (or sometimes final average salary). The benefit percentage is a fixed rate for each year of service (commonly 1.25%–2.5%).

How it works

A unit benefit plan credits a retirement benefit for every year an employee works for the employer. At retirement, the plan multiplies the employee’s total years of service by the benefit percentage and by the chosen salary measure to produce the annual pension.

Example:
* Years of service: 30
Benefit percentage: 1.5% (0.015)
Career average salary: $70,000
Annual benefit = 30 × 0.015 × $70,000 = $31,500

Plans using the unit benefit formula typically require actuarial services to determine funding requirements and to value liabilities. Because the employer funds and manages the plan’s investments, the employer assumes investment risk and must make up any shortfalls.

Advantages and disadvantages

Advantages
* Rewards employee tenure: benefits increase with years of service, encouraging retention.
* Predictable benefit formula: employees know how retirement benefits are calculated.

Disadvantages
* Cost and complexity: actuaries are needed to calculate liabilities and funding contributions.
* Employer bears investment and longevity risk: poor investment returns or longer-than-expected retiree lifespans can increase employer contributions.
* Less portability: benefits are tied to years of service with the sponsoring employer.

Relation to defined benefit and qualified plans

A unit benefit plan is a type of defined benefit plan, where benefits are determined by a formula rather than by investment returns in an individual account. Defined benefit plans are often tax-qualified (meeting Internal Revenue Code requirements), which makes employer contributions tax-advantaged. Qualified plans can also help employers attract and retain employees.

In contrast, defined contribution plans (like typical 401(k) accounts) depend on contributions and investment performance; the employee bears investment risk.

Contribution limits (context for qualified plans)

For tax-qualified plans that allow employee salary deferrals, the IRS sets contribution limits. For 2024:
* 401(k) elective deferral limit: $23,000
Catch-up contribution for age 50+: $7,500
Total annual contribution limit (employee + employer) for defined contribution plans: $69,000 ($76,500 including catch-up)

Sources

• Internal Revenue Service: guidance on retirement plan distributions, 401(k) qualification requirements, and 2024 contribution limits.