Defined benefit plans and defined contribution plans are two employer-sponsored ways of helping to provide employees with a comfortable retirement. The difference between them lies primarily in who takes responsibility for funding the plans, managing the assets, and, ultimately, ensuring that retirees actually enjoy financial security. A defined benefit plan is the responsibility of the employer, while the employee takes responsibility for a defined contribution plan. We’ll discuss the differences as well as the pros and cons.
A financial advisor can help you get a handle on options for saving for retirement.
Defined Benefit Plans
Defined benefit plans, also known as pensions, are entirely overseen by the employer. The employer uses a formula based on a worker’s years with the company, age and salary to determine how much the worker will get in retirement benefits. It’s the employer’s responsibility to set aside money to fund the benefits and manage investing the assets.
When the worker retires and stops drawing a paycheck, the company starts sending monthly benefits. The benefit is a set amount, sometimes indexed to inflation but otherwise unvarying. This makes a pension benefit highly reliable.
Pension plans are, however, also burdensome to employers. This is because they are on the hook to pay the benefits no matter how their business or pension fund investments are doing. As a result, pensions have declined in popularity significantly over the last few decades in favor of defined contribution plans.
Defined Contribution Plans
In a defined contribution plan, the employer sponsors the plan. But it’s the employee’s responsibility to contribute money to the plan, sometimes with an additional contribution from the employer, and select the investments. The employee’s due diligence and skill determine how much money will be in the plan when the retirement date arrives.
If contributions are lacking or investment performance is poor, the amount of money in the plan will reflect that. The financial resources available to pay for retirement depend entirely on the amount of money in the plan. And the employer does not guarantee any fixed amount of retirement benefit.
Employees usually have to opt into defined contribution plans and decide how much salary to defer. The employer may also match employee contributions up to a limit. The employee will also have to make selections from a menu of investment alternatives and do any necessary balancing or other portfolio management on their own.
Salary deferral contributions are generally tax-advantaged, as is the case with the 401(k) defined contribution plans that have largely supplanted pensions. That means deferrals are deducted from current income, providing a tax benefit today. Earnings also grow untaxed until withdrawal, when they are subject to income taxes at the employee’s normal rate.
Comparing Defined Benefit and Defined Contribution Plans
Employers today broadly favor defined contribution plans over defined benefit plans because of their lower cost and lack of responsibility for maintaining set benefit payouts. For employees, defined contribution plans have both pluses and minuses.
Defined Benefit Pros and Cons
Defined benefit pros include stability since the employer guarantees benefits will be paid. Pensions are also backed by the Pension Benefit Guarantee Corporation (PBGC) in the event the pension fund is unable to fulfill its financial responsibilities.
Pension benefits may also be indexed to inflation, and normally charge low fees, which can contribute to better investment performance.
On the con side, employees covered by a pension may receive reduced benefits if they take a job at a different company. Also, employees usually can’t opt out of participating in a pension plan. This can reduce their flexibility if they would be better off receiving financial benefits now rather than in retirement.
Defined Contribution Pros and Cons
Defined contribution plans have become the standard type of retirement plan because they save employers money and shift responsibility for financing retirement to employees. Employees have reasons to both like and dislike defined contribution plans.
The best thing about defined contribution plans is that they are widely available, while corporate pensions are much less common. Defined contribution plans also give employees more control.
They can decide whether or not to participate, how much to contribute, and how to invest plan assets. Defined contribution plans are portable, so employees can shift jobs without leaving retirement plans behind. Current tax benefits represent another plus.
The major downside of defined contribution plans is that they are less reliable. There is no guarantee the employee will have any particular quantity of financial resources in retirement.
In fact, many employees don’t start contributing to defined contribution plans soon enough. And they don’t defer enough salary and don’t manage the investments in their plans well enough to fund a comfortable retirement.
Bottom Line
Defined benefit plans and defined contribution plans take different routes to funding retirement. Employers take responsibility for this task with defined benefit plans, funding and managing the plans and guaranteeing payment of set benefits based on a worker’s tenue, age and earnings. Employers shoulder the work of retirement planning with defined contribution plans, funding them with deferred salary and selecting investments in the hope but without any guarantee of eventual benefits.
Tips for a Financially Successful Retirement
- No matter how close or far you are from retirement, juggling all of your accounts and investments on your own can get difficult. A financial advisor can take a comprehensive look at your finances and help manage your money on your behalf. If you don’t have a financial advisor yet, finding one doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- During the retirement planning process, it’s important to think about the retirement tax laws of the state you want to retire in. By minimizing your retirement tax burden, you can maximize the value of your savings in retirement.
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