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 and employers (if they choose) to contribute and invest funds overtime 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.
Key Takeaways
- 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.
Defined-Benefit 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 due to 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.
While they are rare in the private sector, defined-benefit pension plans are still somewhat common in the public sector—in particular, in government jobs.
Defined-Contribution Plan
Defined-contribution plans are funded primarily by the employee. But many employers make matching contributions to a certain amount.
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, and 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 the contributions and choosing investments offered by the plan. Contributions are typically invested in select mutual funds, which contain a basket of stocks or securities, and money market funds, but 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 2021, for example, the most an employee can contribute to a 401(k) in one year is $19,500, or $26,000 if they are 50 or older. For 2022, the maximum amount rises to $20,500, or $27,000 if they’re 50 or above.
Defined Benefit Pension Plan
Advisor Insight
Chris Chen, CFP®, CDFA®
Insight Financial Strategists LLC, Waltham, Mass.
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.