Defined Contribution vs. Defined Benefit Plans

Many employers have made retirement plans available for their employees, and sometimes there are multiple types of plans that the employee can participate in.  These retirement plans fall into two categories: Defined Contribution and Defined Benefit plans.  In this article we’ll cover the differences between the two types of plans.

Defined Benefit (DB) Plans

The older type of retirement plan is the Defined Benefit Plan. (We’ll refer to this as DB for the rest of the article.)  DB plans are generally the old standard pension-type of plan, and this category of plan is named as it is because the benefit is a defined amount in a pension plan.

By a defined amount, we mean that a formula is used to calculate the amount of pension that you’ll receive.  The formula typically uses factors such as your years of employment, your average salary (either over your entire career, or perhaps over the most recent five years, as an example), your age when you begin receiving the pension payments, and other factors.

Let’s look at an example. Your final five years of salary averaged $50,000 per year and you had 25 years of service with the company. Your defined benefit calculation might be something like 2% per year of service times the average salary during your final five years, or 50% of $50,000 – for a pension of $25,000.  Pension calculations can be very complicated, this was a very simple example.  A few of the variances include:

• a flat amount formula unrelated to years of service or earnings;
• a flat percentage of earnings, unrelated to years of service;
• a flat amount per year of service, unrelated to earnings; or
• a percentage of earnings per year of service, reflecting both earnings and service.

Once the amount of your pension is defined, you will know how much benefit you’ll receive when you begin receiving it – and it’s a guarantee.  It is for this reason that DB plans are often considered to be more valuable than Defined Contribution (DC) plans.  As you’ll see in the next section, DC plans don’t have such a guarantee.

This guaranteed benefit comes at the cost of the employer.  Since the employer must provide that specific benefit, variables such as the rate of return on investments, inflation, and the like, can have a negative affect on the funds available to pay the benefit. This can cause the employer to have to purchase insurance products that will account for those variables, which can be quite costly.

Defined Contribution (DC) Plans

This type of retirement plan is the newer of the two types, but it’s also the one that requires more participation from the employee.  The DC plan is generally a savings plan, such as a 401(k) plan, and the employee and employer make contributions to the account.  The amounts that can be contributed to the plan are limited by IRS definitions, and that’s the reason that these plans are called Defined Contributions – since the Contribution amount is defined.

There are a couple of types of DC plans – profit-sharing plans and stock bonus plans.  These can also be mixed together to create a hybrid DC plan.  The profit-sharing type of plan is where the profits of the business are shared among the employees in cash, where the stock bonus plan is a distribution of company stock to the employees.

Since the contribution is the amount that is defined in a DC plan (rather than the benefit, as in DB plans), the benefit that the employee will receive during retirement is not known.  The amount that the employee may receive during retirement is based completely on the following factors:

1. How much the employee and employer contribute to the plan;
2. What rate of return the plan experiences; and
3. How long the funds are allowed to grow in the plan.

The amount that the employee contributes to the plan is totally up to the employee – these plans are voluntary in nature.  Contributing more to the plan is the primary thing that you can change to improve your chances of increasing the amount of funds that your plan will eventually have upon your retirement.

Rates of return are completely variable – this depends solely on what happens with the various investment choices that you use for investing your DC account.  If the investments you choose increase in value over time (which we hope that they would) then you’ll see your investment nest egg increase in value.  Sometimes you’ll see the investments go up in value, sometimes the investments will go down.

This is the same for both DB and DC plans – but in the case of the DC plan you’re not guaranteed a specific benefit, so reductions to your investments are borne solely by you, the account holder.  On the other hand, if there is a reduction experienced by the investments in a DB plan, the employer (or the insurance company that owns the pension annuity) must make up the difference to ensure that you receive the benefit that has been defined for you.

Comparison

Below is a table which compares the two types of plans: