Defined-Benefit vs. Defined-Contribution Plan: An Overview
Employer-sponsored retirement plans are divided into two major categories: defined-benefit plans and defined-contribution plans. As the names imply, a defined-benefit plan—also commonly known as a traditional pension plan—provides a specified payment amount in retirement. A defined-contribution plan allows employees to contribute and invest in funds and other securities over time to save for retirement.
These key differences determine which party—the employer or employee—bears the investment risks and affects the cost of administration for each plan. Both types of retirement accounts are also known as superannuations.
- Employers fund and guarantee a specific retirement benefit amount for each participant of a defined-benefit pension plan.
- Defined-contribution plans are funded primarily by the employee, as the participant defers a portion of their gross salary; employers can match the contributions up to a certain amount, if they choose.
- A shift to defined-contribution plans has placed the burden of saving and investing for retirement on employees.
- The most popular defined-contribution plan is the 401(k).
- A steady trend has emerged of companies favoring defined-contribution plans over defined-benefit plans.
Defined Benefit Pension Plan
Defined-benefit plans provide eligible employees guaranteed income for life when they retire. Employers guarantee a specific retirement benefit amount for each participant that is based on factors such as the employee’s salary and years of service.
Employees have little control over the funds until they are received in retirement. The company takes responsibility for the investment and for its distribution to the retired employee. That means the employer bears the risk that the returns on the investment will not cover the defined-benefit amount that will be due a retired employee.
Because of this risk, defined-benefit plans require complex actuarial projections and insurance for guarantees, making the costs of administration very high. As a result, defined-benefit plans in the private sector are rare and have been largely replaced by defined-contribution plans over the last few decades. The shift to defined-contribution plans has placed the burden of saving and investing for retirement on employees.
Defined-benefit plans are broken down into two payment options: annuity and lump-sum payments. In an annuity payment plan, the payment is spread out and paid monthly until death. A lump-sum payment is the entire value of the plan paid at one time.
Opting to take defined payments that pay out until death is the more popular choice, as you will not need to manage a large amount of money, and you're less susceptible to market volatility.
While they are rare in the private sector, defined-benefit pension plans are still somewhat common in the public sector—in particular, with government jobs.
Defined-contribution plans are funded primarily by the employee. The most common type of defined-contribution plan is a 401(k). Participants can elect to defer a portion of their gross salary via a pre-tax payroll deduction to the plan. The company may match the contribution if it chooses, up to a limit it sets.
As the employer has no obligation toward the account’s performance after the funds are deposited, these plans require little work, are low risk to the employer, and cost less to administer.
The employee is responsible for making contributions and choosing investments offered by the plan. Contributions are typically invested in select mutual funds, which contain a basket of stocks and/or other securities, and money market funds. However, the investment menu can also include annuities and individual stocks.
The investments in a defined-contribution plan grow tax-deferred until funds are withdrawn in retirement. There is a limit to how much employees can contribute each year. For 2022, for example, the most an employee can contribute to a 401(k) is $20,500, or $27,000 if they are 50 or older and make the catch-up contribution of $6,500. For 2023, the limit rises to $22,500, or $30,000 with the $7,500 catch-up contribution.
Those with a defined-contribution plan can also contribute to a 403(b). While both the 403(b) and 401(k) are tax-deferred, a 403(b) is much less common as it is restricted to those in non-profit, charitable organizations, and public schools and colleges. 403(b) plans are often managed by insurance companies and offer fewer investment options when compared to a 401(k). which is often managed by a mutual fund.
Chris Chen, CFP®, CDFA®
Insight Financial Strategists LLC, Waltham, MA.
It’s all in the nomenclature. Defined-benefit plans define the benefit ahead of time: a monthly payment in retirement, based on the employee’s tenure and salary, for life. Usually, the funding expense accrues entirely to the company. Employees are not expected to contribute to the plan, and they do not have individual accounts. Their right is not to an account, but to a stream of payments.
In defined-contribution plans, the benefit is not known, but the contribution is. It comes in a designated amount from the employee, who has a personal account within the plan and chooses investments for it. As investment results are not predictable, the ultimate benefit at retirement is undefined. Nevertheless, the employee owns the account itself and can withdraw or transfer the fund, within plan rules.
Defined-Benefit Plan vs. Defined-Contribution Plan Example
Many private-sector employees are offered and participate in a defined-contribution plan. Such plans carry less risk for the employer as they are not responsible for managing the account themselves. They also offer much more flexibility to the employee.
If John were to contribute to a defined-contribution plan such as the popular 401(k), he would be able to make his own investment decisions for the money in his account (although investment choices are limited to what the plan offers).
He could, for example, take an extremely aggressive approach with his investments since he is young and has time to weather a potentially volatile market. His company offers a 3% match, and he adds that money to what he invests for his retirement.
When John reaches retirement age, he starts making withdrawals from the plan. Over the course of his career, he adjusted the investments in his account to ensure that they matched his changing investment profile. As he approached retirement age, John made sure he invested less aggressively to try to maintain the stability of his account's value.
If John were to take the defined-benefit route, his employer would take his contributions and either hand them to an outside investing firm or manage the contributions themselves. John has no say in what the company invests in, and he has to trust that they will be able to make their payouts from the plan, come retirement.
If the company makes a mistake when investing and does not have the amount to pay John when he is ready to receive it, there isn't much John can do. He has saved a lot of time researching investments and making his own investment decisions. However, he lacked the control over his investments that he would have had with a defined-contribution plan. This lack of control is why most in the private sector prefer a defined-contribution plan.
What Is the Difference Between a 401(k) Plan and a 403(b) Plan?
A 401(k) plan is a defined-contribution plan offered to employees of private sector companies and corporations. A 403(b) plan is very similar, but it is offered by public schools, colleges and universities as well as churches and charities. According to the IRS, investment choices in a 403(b) plan are limited to those chosen by the employer.
Why Is a Defined-Contribution Plan More Popular With Employers?
A defined-contribution plan is more popular with employers than the traditional defined-benefit plan for a few reasons. With the former, employers are no longer responsible for managing investments on behalf of employees and ensuring that they receive specific amounts of money in retirement. The employees themselves have to manage that outcome. Defined-contribution are also less complicated and expensive to manage.
Can SEP IRAs Be Combined With a Defined-Benefit Plan?
You can combine a SEP IRA with a defined-benefit plan, depending on whether or not the SEP is a model SEP or a non-model SEP. The type of SEP is determined by the filing of IRS Form 5305, and you would need to confirm which type of SEP you have with your SEP custodian.
The Bottom Line
Defined-benefit plans and defined-contribution plans are two retirement savings options. Defined-benefit plans, otherwise known as pension plans, place the burden on the employer to invest for their employees' retirement years and deliver a defined monthly amount once they retire. They are complicated and expensive plans to administer. And, they are much less common today than they once were.
More ubiquitous in recent decades is the defined-contribution plan, such as a 401(k) plan. With these plans, employees have the responsibility to save and invest for their retirement years. They are less expensive and much easier to sponsor than defined-contribution plans and thus, are more popular with employers.
Defined-contribution plans are also popular with employees because they maintain control over their money and how it's invested (across a plan's available investment options). They can feel more assured that, with consistent and long-term saving and investing, the money will be there for them when they need it.