Defined-Benefit Pension Plan vs. Defined-Contribution Plan: An Overview
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. These types of retirement accounts are also known as “superannuations.”
- There are two types of employer-sponsored retirement plans: defined-benefit pension plans and defined-contribution plans.
- Defined-contribution plans are funded primarily by the employee, where the participant defers a portion of gross salary and the company matches the contribution.
- Employers guarantee a specific retirement benefit amount for each participant of a defined-benefit pension plan.
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 is the 401(k) plan. Participants may elect to defer a portion of their gross salary via a pre-tax payroll deduction to the plan, and the company may match the contribution 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 and are low risk to the employer. The employee is responsible for directing the contributions and investments.
Defined Benefit Pension Plan
Employers guarantee a specific retirement benefit amount for each participant in a defined-benefit plan. The amount 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 due to the retired employee.
Because of 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’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.