Defined Benefit vs. Defined Contribution Plan Basics

Comparing Pension Plans

Defined Benefit vs. Defined Contribution Plan Basics
February 14, 2014

There are typically two forms of retirement plans being offered by employers today: The defined benefit plan and the defined contribution plan. There are quantifiable differences between the two, so it pays to know how they work, and which plan could work best for you.

  • Defined benefit plan - In a Defined Benefit plan, your employer defines a future benefit amount you will receive and is obligated to fund that amount regardless of how investments within the plan perform. This obligation creates significant uncertainty – and long-term risk – for the company. Your employer pays for this plan, so you don’t have to shell out anything to participate. Good financial news for you, except defined benefit plans are being phased out from most workplaces in favor of defined contribution plans, due to the risk factor mentioned above.

    The pension — or annuity — you will receive at retirement age is based on the number of years you have worked for your employer and your salary. Beginning at age 65 (what most plans consider “normal retirement age”), you will receive payments over your lifetime. In some clases, those payments will transfer to a spouse or partner after you die.

  • Defined contribution plan - This is the most common retirement plan available today, because it is less risky for businesses to sponsor. In a defined contribution plan, you finance your own retirement through tax-deductible withdrawals taken from your weekly or monthly paycheck. This money is placed into your 401(k) or 403(b) plan where you have the ability to direct how it is invested (into stocks, bonds, money market, etc.) over time. All monies deposited into your plan, plus the investment returns over time, accrue on a tax-deferred basis. Therefore, the combined tax benefits of these plans are extremely attractive. The money available to you at retirement from a defined contribution plan will equal the amount of your account balance at that time.

    Another positive side to a defined contribution plan is the matching of funds by many employers. This is typically a 50% to 100% match of your own contribution up to specified percentage of your total pay (usually 6%). No matter the amount that your employer is willing to match, consider all of it “free money.”

In rare instances, you may find yourself working for a company that offers both defined benefit and defined contribution plans. If you can participate in both, do so by all means. However, if you must choose, it is normally better to participate in the defined contribution plan. That is because your employer has probably scaled back its financial participation in any defined benefit plan, leaving you with a pension that may not meet your financial needs once you are ready to retire. If such a choice is presented to you, consult with a trusted financial advisor to evaluate each option properly.

Be careful when investing in company stock

Some employers will match your retirement plan contributions with company stock rather than with cash. While holding company stock may seem like a good idea, be careful how much of it will make up your retirement plan. (Google “Enron stock option plan” to learn how their employees suffered catastrophic losses with their company stock.) If you’re allowed to choose between company stock and a dollar-for-dollar matching contribution, try to keep your company stock investments at no more than 20% of your portfolio. Some experts say it should be closer to 10% or 15%.

Study the value of your company’s stock and determine how healthy your employer’s financial future appears. It is advisable, as with all investment decisions, to consult an outside authority when possible to help you make a better-informed, unbiased decision.

The choice is always yours to make

Should you find that your employer offers only a defined benefit plan or a defined contribution plan – but not both – you are under no obligation to enroll in either. But as we stated earlier, the excellent tax-benefits provided by Defined Contribution plans, combined with the likelihood of an employer match, means you would normally be wise to enroll in such a plan.. In addition to these two types of plans, you should also explore other tax advantaged retirement vehicles such as traditional IRAs, Roth IRAs and Health Savings Accounts. By investing intelligently in multiple retirement savings vehicles, you can more rapidly contribute to your future well-being.

Let the free Retirement Planner by MoneyTips help you calculate when you can retire without jeopardizing your lifestyle.

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