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.
The Advisor Insight
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. Since investment results are not predictable, the ultimate benefit at retirement is undefined. But the employee owns the account itself and can withdraw or transfer the fund, within plan rules.
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