Defined-Benefit vs. Defined-Contribution Plans: What’s the Difference?
Defined-Benefit vs. Defined-Contribution Plan: An Overview
Employer-sponsored retirement plans can be broken down into two broad categories: defined-benefit plans and defined-contribution plans. The names are self-evident – a defined-benefit plan, also known as a traditional pension plan, guarantees an employee a certain amount of payment in retirement. A defined-contribution plan provides employees with an opportunity to contribute to and invest in funds and other securities over the years and accumulate wealth for retirement.
These fundamental differences determine which party – the employer or the employee – incurs investment risk, and they determine the managerial cost of each type of plan. Accounts of either type are sometimes referred to as a superannuation elsewhere.
Key Takeaways
A defined-benefit pension plan is one in which an employer provides and guarantees the retirement benefit for each participant.
Defined-contribution plans are funded primarily by the participant, because the employee’s contributions are a percentage of their gross salary, with the employer matching contributions up to a predetermined amount, if they choose to do so at all.
The transition to defined-contribution plans puts the responsibility for saving and investing for retirement squarely in the hands of employees.
The most popular defined-contribution plan is the 401(k).
A steady trend has emerged of companies favoring defined-contribution plans over defined-benefit plans.
Defined-Benefit Plan
A defined-benefit plan is a type of retirement plan where upon retirement, eligible employees can receive a monthly lifelong income. The employer will guarantee its employees an amount of retirement benefit for each participant based on the employee’s salary and length of employment.
The money is out of the employees’ hands until they see it in their bank account when they retire. And the employer, not the employee, bears the risk that favourable returns on the invested money won’t cover what must be paid to the worker by virtue of the defined benefit.
This risk necessitates complex actuarial projections and insurance for guarantees, and these administration costs remain very high, which is a reason why, in the private sector, defined-benefit plans are a rarity and have been effectively supplanted over the past few decades by defined-contribution plans, which place the burden of saving for retirement on employees.
There are two forms of payment for defined-benefit plans, an annuity and a lump-sum payment, where an annuity payment plan would be spread out and paid monthly until death, and a lump-sum payment would be the value of the plan in return for a one-time payment.
Taking defined payments that promise to pay out until death: that’s a more widely elected option. You won’t have to manage as much money, and you’re not as exposed to market fluctuations.
Although they are rare in the private sector, defined-benefit pension plans are still somewhat common among the public: that is, with government jobs.
Defined-Contribution Plan
A defined-contribution plan is funded primarily by the employee. Most defined-contribution plans are 401(k) plans. Participants will voluntarily elect to contribute a pre-tax dollar amount through a payroll deferral. If the company chooses, it might match a participant’s contribution up to a specific company maximum.
Because the employer owes no fiduciary duty to the performance of the accounts once the funds have been deposited, these plans are largely no-work, low-risk for the employer and have reduced administrative costs.
The employee will be making contributions to, and selecting investments from, one or more of the plan’s trusts. Contributions are typically invested in one or more mutual funds, or other collective investment vehicles. A mutual fund is a pool of money from a group of stockholders invested in a basket of stocks (and, sometimes, other securities). The investment menu might also include annuities and other individual stocks.
Investments in a defined-contribution plan accrue on a tax-deferred basis until disbursed in retirement. There is a limit on how much employees can contribute to an account per year. For instance, the 401(k) employee contribution limit is $22,500 for the calendar year 2023. Those over 50 years old can contribute up to $30,000 with the additional $7,500 catch-up allowance. In calendar year 2024, the standard limit is $23,000, meaning those over 50 years can contribute up to $30,500.
The 403(b) is a different kind of defined-contribution plan – it is tax-deferred, but much less common, available only to those working for non-profit or charitable institutions, and for public schools and colleges. Many 403(b) plans are administered by insurance companies, and generally provide fewer ways of investing than is possible with the 401(k). Mutual funds usually administer the 401(k).
Advisor Insight
Chris Chen, CFP®, CDFA®
Insight Financial Strategists LLC, Waltham, MA.
Just look at the names. Defined-benefit plans define the benefit in advance: a certain level of payment expected in retirement – whether that takes the form of a monthly benefit based on the employee’s pay and service (‘Cash Balance’ plans) or a guaranteed lump sum – where the employer bears all the cost of funding. The worker is not expected to contribute to the plan (at least not coherently) and does not own any sort of ‘account’. The benefit is not to a privatised account, but to a stream of payments.
In defined-contribution plans, the benefit is not specified, but the contribution is. It is a specified amount that is put in by the employee, who establishes a personal account within the plan and selects the investments for the account. Since the investment results are not known in advance, the benefit at retirement is likewise unknown, but the employee owns the account as such and can withdraw or transfer the balance to another plan as permitted under the rules of the plan.
Defined-Benefit Plan vs. Defined-Contribution Plan Example
Most private sector workers have access to and indeed participate in a defined-contribution plan. The risk to the employer is vastly less – the worker’s retirement balance in the plan is not the employer’s problem; they do not run the account themselves – and is considerably more flexible.
John’s Defined-Contribution Plan
If John contributes to a defined-contribution plan, such as the popular 401(k), he makes the investment choices in his account (though he has only what the plan offers).
For instance, he can afford to invest in a very aggressive strategy because he’s young and has time to withstand a possibly volatile market. His firm matches 3 per cent of what he puts in, and he adds that to the years he invests in his own retirement.
When John turns 65, he begins to make withdrawals from the plan. Over the course of his working life, he has tweaked the investments in his account to correspond with his changing investment profile. As he neared retirement date, he reduced his aggressive investments to try to stabilise the value of his account.
John’s Defined-Benefit Plan
Instead, if John’s employer offered a defined-benefit plan, it would be John’s employer who would fund the pension supported by its own investments, perhaps with some extra contributions from John. The company would then turn that pension money over to an outside investment firm to manage it for the employee, or (more commonly) it would manage the funds on its own. John has no idea what he’s invested in, and he’ll need to trust that his company can meet its payouts from that fund when he retires.
If the company chooses poorly and doesn’t have the money to pay him when he is ready to receive it, there’s not much John can do, except that he didn’t have to spend the money or time that he would have had to spend researching investments and making decisions. The point is that most employees don’t have control over the investment of their savings, which could otherwise be invested in a defined-contribution plan where they would be in control.
What Is the Difference Between a 401(k) Plan and a 403(b) Plan?
A 401(k) plan is a defined-contribution plan that is made available by employers of such private sector companies and corporations. 403(b) is very similar, but it is made available by public schools, colleges, universities, churches, and charities. Based on instructions from the IRS, in a 403(b) plan, investments are limited by choices made by the employer.
Why Is a Defined-Contribution Plan More Popular With Employers?
A defined-contribution plan is more appealing to employers than a defended-benefit plan for more than one reason.The first is that the employers aren’t responsible anymore for investing for their employees’ retirement plan and they no longer need to promise a certain amount of money to their employees when they retire.So the employees control themselves the final outcome.But those plans are also way easier and less expensive to manage.
Can SEP IRAs Be Combined With a Defined-Benefit Plan?
SEP is a type of individual retirement account that can be paired with a defined benefit plan. SEPs are split into model SEPs and non-model SEPs, and which one you’ll structure depends on whether or not the owner of the SEP files IRS Form 5305. You can ask your SEP custodian which type of SEP you have.
The Bottom Line
There are two popular types of retirement savings options: defined- benefit plans, or ‘pensions’, and defined- contribution plans. Defined-benefit plans are prefered by most employees because they deliver a defined amount of money monthly in retirement. The reason defined-benefit (pension) plans are not as common as they once were because they put the burden on the employer to invest for employees’ retirement years.
More common in recent decades is the defined-contribution plan, such as a 401(k) plan, in which employees are responsible for saving and investing for their post-work lives. These are less expensive and easier to sponsor than defined-benefit plans, and are consequently much Among workers, however, schemes are even less popularit plans. Whereas income in retirement, with defined contribution, employees are left to rely on themselves to save – and voters (or, at best, workers) don’t. Forty per cent of Americans, it’s estimated, enter old age living off Social Security alone, with no other savings.