How does a defined benefit pension plan differ from a defined contribution plan?
Employer-sponsored retirement plans are divided into two categories of plans: defined benefit pension plans and defined contribution plans. As the names imply, a defined benefit pension plan provides a specified payment amount in retirement, while a defined contribution plan allows employees and employers to contribute and invest funds 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.
Defined Contribution Plans
Defined contribution plans are funded primarily by the employee, called the participant, with the employer matching contributions to a certain amount. The most common type of defined contribution plan, which many people are familiar with, is a 401(k) plan. A participant may elect to defer a portion of his gross salary via a pretax payroll deduction to the plan, and the company matches according to its summary plan description, or SPD. The contributions can be invested, at the participant's direction, in select mutual funds, money market funds, annuities or stock offered by the plan. As the employer no longer has any obligation on the account's performance after the funds are deposited, these plans require little work and are low risk to the employer. The employee must direct contributions and investments to grow the assets adequate for retirement.
Defined Benefit Plans
Employers guarantee a specific retirement benefit amount for each participant of a defined benefit plan, which can be based on the employee's salary, years of service or a number of other factors. Employees have little control over the funds until they are received in retirement. The employer bears the investment risk of ensuring the defined benefit amount is able to be paid to the retired employee. Due to this risk, defined benefit plans require complex actuarial projections and insurance for guarantees, making the costs of administration very high. This has made defined benefit plans all but obsolete.
It is all in the nomenclature:
Defined Benefit Plans define the benefit ahead of time. That benefit is usually a monthly payment in retirement, based on the tenure of the employee, his or her salary, and possibly other factors. Payments are usually defined to be for the lifetime of the employee. Employees are not usually expected to contribute to the plan, and as such they do not have individual accounts. The employee right is not to an account, it is to a stream of payments.
Defined Benefit Plans used to be common across large American companies. They are expensive to maintain as they require regular contributions from the employer to be funded. As a result, defined benefit pensions are often underfunded.
The funding expense usually accrues entirely to the company. Since the 1980's . companies have progressively reduced their defined benefit commitments, partially to reduce costs. Currently, most defined benefit plans are for government employees, union employees, with a smattering of legacy plans in corporate America.
In Defined Contribution Plans, the benefit is not known, but the contribution is. The contribution usually comes primarily from the employee, although many employers also have a company match. The advent of the defined contribution plan has allowed corporate America to disengage from defined benefit plans and to push the responsibility for retirement planning on the employee.
As opposed to defined benefit plans, employees have accounts in defined contribution plans. Subject to the vesting of the employee match, the money in the account is the employee's. Unlike defined benefit plans, the employee's retirement money is portable, ie it can be withdrawn or transferred to another account, within the limits of the rules. Some of the common defined contribution plans include 401(k), 403(b), 457, IRA, Roth IRA, SIMPLE IRA, and SEP IRA.
Employees in Defined Contribution companies have a choice for investments in their account. Most plans have a choice of mutual funds that attempts to cover the universe of possibilities, including fixed income and equity funds. Given that everyone's investment result will differ, and are no inherently predictable, the benefit at retirement is an unknown, unlike defined benefit plans.
Defined benefit pension plans are becoming far less common, due to the high cost to employers. Generally, when you retire, you start receiving your benefit. It is a set amount, and continues until you die. Some pensions offer a survivor clause, whereby you can take a reduced amount, in exchange for the payments continuing for a surviving spouse. The benefit amount is usually based on your average salary, years of service, etc.
A definent contribution plan is like a 401(k). You, and in some cases your employer, contribute a certain amount each paycheck. At retirement, the amount you receive, and for how long, isn't certain as it is with a defined benefit plan. Rather, you will draw down on the sum of your account, for as long as it will last. Many people solicit the help of a financial advisor to determine how much they can afford to withdraw annually, so that the sum can sustain itself throughout the rest of their life.
In a defined benefit plan, the obliger (the employer) assumes all market risk - whether the value of the funds goes up or down, they are obligated to pay the same amount to the retired employee. In a defined contribution plan, the employee assumes all market risk - if the value of the account goes up or down, the amount they can afford to withdraw in retirement will fluctuate accordingly.
A defined benefit is defined at retirement age. Then calculations are made to figure out what kind of contributions need to be made by the employer based on age, salary etc of employee.There are limits per year, per employee.
A defined contribution plan, where contribution is defined and employer and employee make yearly contributions at retirement, is based on the market value of the portfolio.
Shikha Mittra AIF(R), PPC(R), CFP(R),CRPs(R),CMFC(R), MBA