John had always been conscientious about saving for retirement, but he was having trouble deciding which type of pension plans would best fit. He asked around, and his coworkers told him about two popular styles: defined benefit and contribution plans. He wanted to learn more about which was better for him, so he researched the fundamental distinctions between these two options. In this article, we will explore the key difference between defined benefits plan and defined contribution plan to help you better understand which type of pension plans may be right for you.
Difference between Defined benefits plan and defined contribution plan
|Feature||Defined Benefit Plan||Defined Contribution Plan|
|How benefit is determined||Benefit is based on a formula that takes into account factors such as an employee’s salary and length of service with the company.||Benefit is based on contributions made and investment returns earned.|
|Guaranteed benefit||Benefit is guaranteed, regardless of how the plan’s investments perform.||Benefit is not guaranteed and depends on the investment performance.|
|Employer funding||Employer is responsible for funding the plan and for making sure that there is enough money in the pension plan to pay the promised benefits.||Employee and, sometimes, an employer contribute money to an individual account.|
|Investment control||Little control over investments, as the investments are chosen and managed by the employer.||Employee has control over how the money in the account is invested.|
|Portability||Not portable, meaning that an employee can’t take their account with them if they change jobs.||Typically portable, meaning that an employee can take their account with them if they change jobs.|
|Benefit size||Typically offers larger benefits than defined contribution plans.||Typically offers smaller benefits than defined benefit plans.|
|Accessibility||Typically, only offered by larger employers, so not all employees have access to them.||Typically, more accessible, as they are offered by a wide range of employers.|
Defined Benefit Plans
A defined benefit plan, also known as a pension plan, is a type of retirement plan in which an employer promises to pay a particular benefit to employees upon retirement. The benefit is typically based on a formula that considers factors such as an employee’s salary and length of service with the company. The employer is responsible for funding the plan and ensuring that there is enough money to pay the promised benefits.
Advantages of defined benefit plans
With the promise of guaranteed retirement income, a defined benefit pension plan can be a unique form of retirement income. We’ll explore several advantages over defined contribution pension plans in this comparison.
✔️ Your retirement income is assured
Employers guarantee to provide a predetermined amount as retirement income – no matter the performance of underlying investments. This makes it more reliable than defined contribution pensions, which may have short-term losses due to economic or stock market fluctuations, even though they tend to grow over time. Plus, organizations such as the Pension Protection Fund will guarantee payments even if companies experience financial troubles or close down.
✔️ You may get lifetime retirement income from some definite benefit plans
Some schemes pay out retirement income for a fixed number of years, while others offer it for life – so long as the company remains solvent. This means your pension won’t run out as certain defined contribution pensions can.
✔️ Retirement income could be linked to inflation
Inflation – when prices steadily rise over time – can erode the value of money if not adequately protected. Defined benefit pensions are often linked to inflation, allowing them to keep up with the cost of living changes and retain their value; for example, if inflation is 2%, then £15,000 becomes £15,300 in the following year.
✔️ No Employees contributions
Unlike many defined contribution pensions where employees need to contribute at least 5% of their salaries towards their pension pot, all contributions towards definite benefit plans are typically taken care of by employers alone. This gives employees more money in their pockets monthly that could be invested into personal pensions – an effective way of increasing one’s retirement fund since extra payments aren’t allowed into definite benefit schemes.
✔️ Your dependents could receive a portion of your pension if you die
If you wish to provide financial and social security for your partner or child after you pass away, you can do so through a definite benefit pension scheme. It may continue paying part or all of your retirement income when you’re gone; depending on when this happens and other factors, this could also be paid out as a tax-free lump sum equal to multiple times your average/final salary.
Disadvantages of defined benefit plans
Employees who benefit from a defined benefit pension can usually enjoy many significant advantages, but they should also be aware of the potential downsides.
❌ Loss of Investment Control
Employees can often choose how their pension is invested with a defined contribution pension. This gives them a chance to select investments that match their values or higher-return options that could lead to more significant growth. However, in a defined benefit pension plan, the employer (or partner) is responsible for the management of the funds, and this could mean slower growth and a lower retirement income.
❌ Reduced Flexibility at Retirement
Defined benefit pensions offer a set income each month after retirement. In contrast, with a defined contribution plan, you can withdraw money in more enormous lump sums when desired or spread your withdrawals over time. You can transfer your money from a defined benefit pension into one of these plans, but you may lose any additional benefits you have been promised.
❌ Employer Financial Difficulties
A significant downside to having an employer-managed plan is that if your employer experiences financial difficulties, your retirement income might also suffer. The Pension Protection Fund (PPF) can provide some coverage, but it may not be enough to give you what was initially promised.
❌ Accessing Funds Early May Not Be Possible
Defined contribution pensions typically allow access from age 55 (increasing to 57 in 2028), while defined benefit plans usually start distributing funds at age 60 or 65. If you need an early influx of cash, this could be problematic, although allowing more time for savings to accumulate may be more beneficial in the long run.
❌ Limited Beneficiaries
It’s possible with many types of pension schemes to leave some money behind for family members or dependants upon death. But this isn’t always available through defined benefit pensions, so there is less choice when appointing beneficiaries.
Defined contribution plan
A defined contribution plan is a type of retirement plan in which an employee and, sometimes, an employer contribute money to an individual account. Typically, the employee chooses how to invest the money in the account, and the retirement benefit is determined by the employee’s contributions and investment returns. The most popular defined contribution plans are 401K plan, 403(b) plans, and the government’s Thrift Savings Plan (TSP).
Advantages of a defined contribution Pension plan
✔️ Contribution flexibility
Participants can choose how much they want to put into their plan, up to the limits set by the plan.
✔️ Employer contribution
Some employers will match a portion of the employee’s contributions, which can help the employee save more for retirement.
When a participant leaves their job, they can take their account balance with them.
✔️ Investment options
Participants can choose how their contributions are invested, which can help them manage risk and make the most money.
✔️ Professional management
Many plans offer professional management of investments, which can help people reach their retirement goals.
✔️ Easy to understand:
DC plan are usually easy to understand and run, so a wide range of employees can use them.
Because the costs are usually split between all plan participants, defined contribution plans can be cost-effective for both employers and employees.
Disadvantages of defined contribution plan
❌ Social Security Risk
Participants are responsible for managing their own account balances and may outlive their savings if they don’t save enough or invest wisely.
❌ Investment risk
The value of investments in a defined contribution plan can change, and if the market does badly, participants may lose money.
❌ Limited Employer Contributions
Employers are not required to put money into the plan, and some may not offer matching contributions.
❌ Administrative costs
Defined contribution plans can have administrative costs like fees for keeping records and managing investments, which can take money out of people’s accounts.
❌ Limited Withdrawals
Participants may have to pay taxes and penalties if they take money out before they reach retirement age.
❌ No guaranteed benefit:
Unlike defined benefit plans, defined contribution plans don’t provide a guaranteed benefit at retirement.
❌ Inflation Risk:
With defined contribution plans, the benefit isn’t changed to account for inflation. This means that the savings may be worth less over time.
❌ Lack of professional management:
Some plans may not offer professional management, which means that participants will have to handle their own account balances and investments or need help from financial advisor.
Should I choose defined benefit or defined contribution?
It is important to consider the benefits of enrolling in a traditional defined benefit pension plan or receiving a match in defined contribution plans, such as a 401(k) or 403(b) plan.
With a defined benefit plan, your pension is typically paid out to you as a guaranteed income based on factors such as your income and how long you’ve worked there. Your employer takes responsibility for investing and funding the money in the plan while with a defined contribution plan, you invest the money contributed to your 401(k)/403(b) account (by you and/or your employer) and receive the balance.
When presented with this choice, it’s important to understand that it generally can’t be changed once made. Here are some considerations when making this decision:
- Which plan can be expected to provide you the most retirement income?
By estimating how much your income will grow over time and how long you’ll work at the company, one can plug those numbers into the defined benefit plans formula to estimate their benefit. For example, if an individual were earning $80k annually for 25 years, they’d get about 40% of that average as their benefit after 25 years or about $2,667 monthly.
On the defined contribution side, one would need to assume an average rate of return on their investments to calculate how much extra they’d have in their plan at retirement. For example, if an individual received an 8% match from their employer and had an average real (after inflation) annualized return of 5%, they’d end up with about $318k which could purchase an immediate income annuity paying roughly $1,700 monthly starting at age 65 in NY.
- Do you prefer stability or flexibility?
While running the numbers is key here, there are other things to consider such as that with a defined benefit plan one might not have the option of taking a lump sum upon retirement while with a defined contribution plan, they would have access to funds throughout their life and potentially pass any remaining on to heirs. Additionally with a defined benefit plans one won’t have worry about investment returns while annuity prices may fluctuate upon retirement so payments may differ than projected (higher if interest rates are higher).
- When do benefits vest?
This is also an important factor when deciding between these two options because otherwise none of these benefits matter if one doesn’t stay with their employer long enough for them vest – which is only 1 year for the defined contribution plan and 10 years for the defined benefit plan.
Overall, it is critical to examine all aspects before submitting your choice regarding pension plans; it could make all the difference in terms of retirement income down the line! You may need to consult a personal financial advisor before finalizing your retirement plan.