Defined Contribution and Defined Benefit Pension Plans

When you think of retiring, it is only natural that you mull over every aspect of your retirement plan as carefully as possible. Just like when you were younger and you wanted to change career, retirement is not something that you decide overnight. Most of the times, it will need careful considerations of existing circumstances and situations and deliberate decision making about your future. And one of the things that probably crossed your mind is whether to go with a defined contribution plan or a defined benefit plan.

Describing it strictly, a defined contribution plan is a type of company retirement plan where the employees choose to defer a certain amount of his/her salary into the retirement plan. Each employee who enters into a defined contribution plan will be given individual accounts. Examples of defined contribution plan include a 401(k), 403(b), individual retirement accounts, profit sharing plans and employee stock ownership plans. These kinds of plans bear all the investment risks and the return of the investment whether positive or negative will be credited to the individual’s accounts. Therefore, the amount of benefits an employee gets from such plans is highly dependent on the income, expenses, gains and loses of the investments.

Most notable advantages of defined contribution plans include some tax breaks on retirement savings; participants are given a certain level of freedom to choose the amount they want to save; employees can choose to fund the funds through payroll deductions; is easily understood by participants; and if the investments have turned out right, the participants will be well rewarded.

The problems with defined contribution plans, however, is that late savers might find it difficult to the build the necessary funds to enter in such retirement plans. Also, if investments turned out to be bad, the participants will bear the full consequences.

Meanwhile, a defined benefit plan promises the participant a specific monthly benefit at retirement. Included in these kinds of plans are the various pensions plans. This is the traditional approach in retirement plans and was often practiced by large businesses and the government. In a defined benefit plan, a participant will receive a monthly stipend the amount of which is dictated by factors like salary, salary upon retirement, and number of years worked.

The good thing about a defined benefit plan is that participants are guaranteed of a retirement income. Also, the plan has no investment risk to participants; cover cost of living adjustments; is definitely not dependent on how the participants were able to save; and just like defined contribution plans offers tax deferred retirement savings medium. The bad news, however, is that these kinds of plan is not applicable to employees who leave before the required retirement age. Sometimes, participants find it hard to comprehend the ins and outs of defined benefit plans.

Both retirement plans still have loyal "followers." However, in recent years more and more companies and employees are preferring the defined contribution plans over the defined benefit plans. Those who prefer defined contribution plans argue that with the plan, participants have the leeway to personalize his/her investment portfolio according to specific needs and situations.

 

Posted by Ardent Editor on Jun 20 2007 in 401k & Company Plans

  • Sponsors