Defined benefit and defined contribution plans are employer-based retirement plans. Defined benefit plans are paid by the employer, offer pension plans, and guarantee a lifelong income. They are also becoming less common. Contribution plans are funded through an investment account. These plans are reliant on the market, and it is possible to outlive the funds. It is the more common form of retirement income.
Retirement is something most workers look forward to, and we are taught from a young age to prepare for it. When you start planning for retirement, two plans you will run across are defined benefit plans and defined contribution plans.
Both defined benefit and defined contribution plans are employer-sponsored retirement plans. But there are a few key differences. For instance, a defined benefit plan is most often funded fully by the employer, while a defined contribution plan is funded by both the employee and the employer.
More and more employers have shifted from offering a defined benefit plan to only offering a defined contribution plan. However, if you have the choice between the two, it is important that you understand the differences between them. Keep reading to learn about these retirement plans and how they can benefit you.
What is a defined benefit plan?
Employees will know exactly how much income they will get after retirement with a defined benefit pension plan. This plan provides employees with a guaranteed income for the rest of their lives. Benefit plans are protected by the Pension Benefit Guaranty Corporation (PBGC).
The retiree can receive the payments in two forms: a lump sum payment, or an annuity payment plan. With a lump-sum payment, the individual can receive the whole retirement fund at once. This is also called a cash balance plan. An annuity plan is divvied out into monthly payments. These are referred to as pensions. In order to receive a monthly pension, the employee generally has to work a set amount of time before retiring.
How payments are set
The amount people earn upon retirement is usually calculated based on their average salary, a percentage set by law, and how many years they work. Generally speaking, the longer people work, the more they earn. The amount a retiree receives stays the same and makes planning and budgeting post-retirement easier.
Not widely available
However, this retirement plan requires a large number of contributors in order to maintain consistent payments. It is very costly and, because of this, the number of companies that offer this plan has scaled back drastically.
Even if you’re lucky enough to have a defined benefit plan, the amount you can expect to receive after retirement may not be enough for the lifestyle you want. Fortunately, there’s no rule saying you have to rely exclusively on your pension. You can also make your own investments before retirement. To learn more, talk to a qualified investment advisor.
What is a defined contribution plan?
A defined contribution pension plan is funded by the employer’s contributions and the employee’s own investments in a tax-deferred investment account. Investments will hopefully build over time. When employees with defined contribution plans retire, whatever amount is in their account is the amount they will have for the rest of their life. IRA and 401(k) accounts function this way.
There are investment risks with this plan. Defined contribution plans are influenced by the market, which could lead to a loss of money. Defined contribution plans also provide a limited amount of income. Once all the money is spent, the benefits are gone. Because of this, some people with this plan may outlive their retirement benefits.
One benefit of these plans, however, is that you have more flexibility with how much you can withdraw. You can often withdraw more often than you could with a defined benefit plan.
Examples of defined contribution plans include:
- 401(k) plans
- 403(b) plans
- Employee stock ownership plans
- Profit-sharing plans
Defined benefit vs. defined contribution: the pros and cons of both
Each plan has its own benefits and downside. If you have the opportunity to choose between these two retirement plans, carefully consider both the good and the bad of each.
Here is a list of the benefits and the drawbacks to consider.
- You will know exactly how much your monthly pension will be when you retire
- The payment amount will not change once it is set
- Payments continue through life, and you will not outlive your pension
- More companies are moving away from this retirement plan
- The amount given does not change, even with inflation
- You may have to work longer than you want in order to receive the retirement benefits in full
Here is a list of the benefits and the drawbacks to consider.
- Easy and flexible to withdraw from retirement income
- You could cash out before you retire
- Offered by most companies, and is a common retirement plan
- Your investments are affected by the market, which could lead to the value lowering
- You could outlive your funds
- The total amount you’ll have in your retirement fund is unknown until it actually becomes time to retire
Which plan is best for me?
Unfortunately, you may not have much of a choice between the two. The majority of companies are moving away from defined benefit plans and switching to contribution plans. If you do have a choice, however, carefully consider the pros and cons of each plan. Benefit plans are great because you cannot outlive them, and you know exactly how much you will have when you retire. But they are costly and offered by very few companies.
What are the advantages of a defined benefit plan and defined contribution plan?
The main advantages of a defined benefit plan are (1) you will not outlive your pension, and (2) it is not reliant on the market. The main advantages of a defined contribution plan are (1) you have flexibility with the amount you can withdraw, and (2) it is offered by most companies.
What are the disadvantages of a defined benefit plan and defined contribution plan?
A defined benefit plan is offered by fewer employees because of how expensive it is for the company. A contribution plan, while more common, puts you at risk of outliving your retirement funds.
What are the two types of defined benefit plans?
The two types of defined benefit plans are cash balance plans and traditional pension plans. Traditional plans guarantee a series of monthly payments for life that begin at retirement. The monthly payments are not determined by how much your employer contributes to the plan.
However, the benefits of cash balance plans are defined in terms of a stated account balance when you retire plus an annual interest credit, which may be a fixed rate of 5% or a variable rate, such as the interest rate on the 30-year Treasury. Typically, employers contribute a minimum of 5% to 8% of the employee’s salary toward the cash balance plan. When a participant becomes entitled to receive benefits under a cash balance plan, the benefits received depend on the balance available.
To illustrate, let’s say Jane has an account balance of $100K when she reaches age 65. If Jane decides to retire, she will have the right to an annuity based on that account balance. Such an annuity might be approximately $8,500 per year for life. However, in most cases, Jane will also have the option to, with consent from her spouse, take a lump sum benefit equal to the $100,000 account balance.
What are the two most popular personal retirement plans?
401(k) and IRA plans are very common. Both of these are also a type of defined contribution plan.
- Defined benefit plans are paid for by the employer and offer monthly pensions or lump sums.
- In the case of defined benefit plans, you receive payments for the rest of your life, meaning you won’t outlive (in theory) your pension.
- Defined contribution plans are investment-based and funded by both the employer and employee.
- A contribution plan is more common and has the possibility to run out during your lifetime.
Start planning for retirement
It’s never too early to start planning for retirement. Look over SuperMoney’s Ultimate Retirement Guide to learn more about retiring and start planning for it.
View Article Sources
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- Defining the Benefits – DB vs DC Plans — Arkansas Public Employees Retirement System
- New To PBGC — Pension Benefit Guaranty Corporation
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- 10 Simple Steps To Planning A Comfortable Retirement — SuperMoney
- Behind on Retirement Savings? How to Reboot Your Retirement Plan — SuperMoney
- How Does Your 401(k) Plan Measure Up? — SuperMoney
- The Complete Guide to 401k Plans — SuperMoney
- Ultimate Retirement Guide — SuperMoney
- Warren Buffett’s Guide to Investing for Retirement — SuperMoney
- What is a Tax-Free Retirement Account (TFRA)? — SuperMoney
Camilla has a background in journalism and business communications. She specializes in writing complex information in understandable ways. She has written on a variety of topics including money, science, personal finance, politics, and more. Her work has been published in the HuffPost, KSL.com, Deseret News, and more.