What is the difference between a defined benefit and defined contribution pension plan?
A huge component of many people’s retirement plans is a pension plan. Pension plans are typically provided by a company on behalf of its employees as a way to save for retirement. The concept is that employees and employers contribute money into the pension plan in the hopes that the account grows to a substantial enough size to provide a solid income after retirement.
A number of years ago there was typically only one kind of pension plan; the defined benefit pension plan (DB). However, due to rising liabilities and costs associate with a DB plan the more common type of pension plan available in today’s employment environment is the defined contribution pension plan (DC).
This article will define each type of plan so you are better prepared to understand which ever plan is available at your company. Most companies either have one or the other, so there is not usually a choice of which plan to join. In the majority of circumstances, the employee will be enroll in a define contribution plan.
What is a Defined Benefit Pension Plan?
The more traditional type of benefit plan is the DB plan. Historically, when people spoke about pension plans it was these plans they were referring to. In these types of plans, the employee knows exactly how much money they will receive in monthly income after they retire from the company. Additionally, DB plans are most often funding by just the employer.
In a defined benefit plan, the income received after retirement is based on a formula. That takes into account the years of service the employee worked at the company and the average salary over a specific number of years. (Typically the past three to five years of employment). Once the employee hits the retirement age as defined by the company the calculated benefit is paid out as monthly income.
There are a number of nuances to DB plans that must be considered. In addition, it should be research properly by employees with access to these types of plans. For example, what happens if the employee decides to wait five years before drawing on the pension (i.e. waiting until 70 years of age instead of 65)? In many plans, the income receive from the pension can be greatly increasing. You and your financial advisor must review if you are able to bridge the gap between 65 and 70 in order to receive that higher income.
What is a Defined Contribution Pension Plan?
A defined contribution pension plan is similar in its purpose when compared to a DB plan. Both are intend to provide an income for retirees.
However, there are two key differences. First, whereas a DB plan will state exactly what income the retiree can expect from the DB plan after retirement. The amount of money receiving from a DC plan is only determined after retirement. Besides that, it is depends entirely on what the investment held in the DC plan have grown to. As employees and employers contribute to the plan, and the stock market goes up over a long period of time. The hope is that the DC plan is big enough to throw off enough income from dividends or other investment income.
The second main difference is that DC plans are often fund by both the employer and employee as opposed to usually just the employer with the DB plan. This requires the employee to contribute funds from their salary into the plan. Which effectively off loads part of the liability for retirement income to the employer.
You May Not Have a Choice
Although the DB plans sound like a much better option since the employer contributes all the money and guarantees a defined benefit upon retirement. The problem is that they are becoming more and rarer. Due to the risk and high administrative costs, DB plans are not offering nearly as often as DC plans today.
As a result, you may have to simply go with the DC plan offered by your company. Although they are not as nice as the DB plan, having any plan is better than nothing. So, if your company offers a DC plan sign up for it and maximize your contributions to it. That way you stand a better chance of generating a large enough portfolio that can throw of a sizable income in retirement.