As an employee, one might be eligible for at least one of the two types of pension plans. Defined contribution plans and defined benefits are both types of pension plans. Both of the pension plan categories are employee-sponsored, and employees are eligible for it upon retirement.
A defined benefit plan is traditionally known as a pension plan and seeks to provide a specific payment amount to the employee at retirement. However, a defined contribution plan allows the employees and their employers to choose to contribute their funds and invest them during their employment period to save it for after retirement.
These retirement plans are also known as superannuation. The difference between the two plans where a contribution plan allows the employers or the employee to choose whether to invest the funds are not, compared to the former plan, plays a significant role in determining who bears the costs of administration of the plan- the employee or the employer. And further, who bears the investment risk for the funds invested.
Defined Benefit Plan
A defined benefit plan will guarantee an income for the employees upon retirement for life. In the case of a defined benefit plan, the employer provides a guaranteed specific amount of pension to the employer based on a certain factor, including the employee’s salary and their years of service within the organization.
These factors determine whether a certain amount would be paid to an employee a pension, or perhaps the employer may as well choose to pay a lump sum amount based on this upon the employee’s retirement. This plan is also known as a conventional pension plan.
Employees generally do not influence managing or deciding how to invest their funds. The responsibility to invest these funds and then distribute them upon the employee’s retirement lies within the organization itself. This implies that the organization must fully bear the risk of investment entirely on its own. If the funds from returns do not cover the retirement pension amount, the loss must be borne by the employer and not the employee.
It is because of this reason that defined-benefit plans essentially require complex actuarial projections and insurances to guarantee any losses. As the entire process becomes complex, this tends to increase the administrative costs associated with this plan.
Due to this reason, employers within the private sector are less likely to use a defined benefit plan and have shifted to the use of a defined contribution plan instead. As a result, now the choice of whether to save and the investment risks are borne by the employee rather than the employer.
However, these plans are still frequently used within the public sector, and especially in government jobs.
Defined Contribution Plan
The employees themselves mainly finance a defined contribution plan. However, an employer may also make a matching contribution to the plan to a certain extent.
One of the most frequently used forms of defined contribution plan is a 401(k). Under this plan, employees can choose to defer a part of their gross salary. This is done by deducting a part of the salary as a pre-tax payroll and contributing it to the plan, and the employer can choose to match this contribution up to a certain limit.
As the plan is mostly funded upon the choice and decision of the employee, the employer has little responsibility to ensure that the account performs well. This also means that the risk associated with the investment is low for the employer, and so is the administration cost of the account.
The employee has control over deciding which investment offers they would like to choose for the plan. They can be chosen from specific mutual funds offered as a part of the plan and contain a range of stocks or securities and money market funds. They may as well include annuities and individual stocks to choose from.
The tax on the defined contribution plan is deferred until the funds are eventually withdrawn upon retirement. However, there are limits in place that define how much employees will contribute to the 401(k) plan each year. For instance, an employee older than 50 years can choose to contribute up to a maximum of $26,000, whereas those below 50 years can contribute to a maximum of $19,500 only.
Defined Benefit vs Defined Contribution Plan
A defined benefit plan will allow the employee to access a pre-determined and guaranteed payment in the future set well ahead of the time with no risk to bear, based on their tenure and their salary during employment years. This allows them to access these funds for life while the entire expense of funding this plan is borne by the employer.
Under this plan, employees are not supposed to make any contributions to their pension plan. So, they do not have access to their personal accounts but rather a series of payments that the employer is responsible for providing them.
On the other hand, in the defined contribution plan, the employee does not have access to a guaranteed amount of return. Instead, they contribute to their accounts and then choose an investment plan to invest these funds into from a select few.
As the returns from these investments can not be guaranteed and are not known, it is not possible to find out the exact amount of benefit that would be there at retirement. However, the employee retains full control of being able to withdraw the funds or transfer them as per the plan’s rules as they enjoy the ownership of the plan.
In the beginning, the defined contribution plan was designed to complement the defined benefit plan rather than be used as an alternative, but this later changed, and now it is used by employers as a complete pension plan on its own.