Defined Benefit Plan and Defined Contribution Plan are two types of retirement accounts. This guide “Defined Benefit vs. Defined Contribution Plans”, finds out what these plans are, what are the differences and also the advantages and disadvantages of both the plans.
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Introduction-Defined Benefit vs Defined Contribution Plans
I fondly recall the days when my father and his brothers (my uncles, of course) relied solely on their employers for securing their retirements (Defined Benefit Plan). Back then, they had no or little control over their retirement savings account, including decisions on how much to contribute, when to contribute, or where to invest their funds for growth.
However, times have changed, and employees now enjoy greater autonomy over their retirement savings accounts (Defined Contribution Plan). They can determine their deferral amounts and, for most of them, choose the investment options that align with their retirement goals.
The traditional approach to retirement savings, known as the Defined Benefit Plan, has evolved to accommodate a newer alternative called the Defined Contribution Plan.
In this guide, “Defined Benefit vs. Defined Contribution Plan,” we will delve deeper into both retirement options, providing clear definitions of each plan, highlighting their respective advantages, disadvantages, and outlining the key differences between them.
Two common types of retirement plans offered by employers are the Defined Benefit Plan and the Defined Contribution Plan.
Each plan has its unique features and advantages, catering to different needs and preferences of employees.
What is a Defined Benefit Plan?
- A Defined Benefit Plan is a retirement plan that guarantees a specific dollar amount of retirement benefits to employees upon their retirement.
- As the name suggests, the benefits are pre-defined, usually based on the employee’s salary and years of service.
- For example it could say that upon retirement the employee would get $10,000 per month. Or it could be defined by a formula which says that upon retirement, the employee would get 10% of his/her salary in the last 5 years of service.
- In this plan, employees are not required to contribute to the retirement fund, and the responsibility of managing investments and assuming the risks lies with the employer.
Advantages and Disadvantages of a Defined Benefit Plan
Advantages of Defined Benefit Plan:
- Guaranteed Retirement Benefits: Employees can be assured of a fixed retirement dollar amount, providing financial security after retirement.
- Employer Responsibility: Employers bear the investment risk, ensuring that employees receive the promised retirement benefits regardless of investment performance.
- Annuity and Lump Sum Options: Employees can choose between receiving the retirement benefits as a monthly annuity or a one-time lump sum amount.
Disadvantages of Defined Benefit Plan:
- Limited Employee Control: Employees have no say in investment decisions or fund management.
- High Administration Costs: Due to the employer’s responsibility for managing funds and ensuring guaranteed benefits, they employ actuarial analysis and other methods to predict the returns as accurately as possible. They either do it themselves or hire a third party. Furthermore, the funds are secured by federal insurance to cover any losses. All these tend to have high administrative costs for the employers.
- Less Prevalent in the Private Sector: Defined Benefit Plans are less common in the private sector, as they require significant financial commitments from employers.
What is a Defined Contribution Plan?
- A Defined Contribution Plan is a retirement plan where employees take an active role in their retirement savings.
- In this plan, employees determine the amount they want to contribute to the retirement fund from their gross salary, and employers may match a portion of these contributions up to a specified limit.
- In most of these plans, the employee also chooses the investment options for them which aligns with their long term goals. For example, they could choose to invest in mutual funds, stocks and other options available with their plan provider.
- The employee chooses the investment types -mutual funds, stocks, money market funds and more.
- The funds grow tax-deferred until they are withdrawn..
- The amount that the employees can contribute to cannot exceed a defined limit set by the IRS for that year.
- The most common type of Defined Contribution Plan is 401k. Check below the contribution limits for 401k.
- Another example is the 403b which is a retirement plan restricted to non-profit, charitable organizations and public schools and colleges.
- Examples of Defined Contribution Plan-401k, 403b, employee stock ownership plans and profit sharing plans.
|Year||Contribution||Catch up contribution (if age is 50 or more)|
Advantages and Disadvantages of a Defined Contribution Plan
Advantages of Defined Contribution Plan:
- Employee Control: Employees have the flexibility to choose the amount they contribute and the investment options, empowering them to tailor their retirement savings to their preferences.
- Portability: Defined Contribution Plans are often more portable, allowing employees to carry their retirement savings with them if they change jobs.
- Tax Benefits: Contributions to Defined Contribution Plans are often tax-deferred, and tax deductible.
Disadvantages of Defined Contribution Plan:
- Uncertain Retirement Benefits: Unlike Defined Benefit Plans, the retirement benefits in a Defined Contribution Plan are not guaranteed and depend on the contributions made and investment performance.
- Investment Risks: Employees are exposed to investment risks, and the final retirement amount can fluctuate based on market performance.
- Contribution Limits: The IRS sets annual contribution limits for Defined Contribution Plans, restricting the amount employees can contribute.
Defined Benefit vs. Defined Contribution Plan – 5 crucial differences
|Aspect||Defined Benefit Plan||Defined Contribution Plan|
|1) Retirement Benefits||Guaranteed fixed amount based on salary and years of service||Benefits based on contributions and investment performance|
|2) Employee Contributions||No contributions required. The employer takes care of the contributions.||Employee determines contribution amount up to IRS limits, employer may match|
|3) Employee Control||Limited control over investments||Full control over investment choices|
|4) Administrative costs to the employer||High due to employer responsibility||Generally lower administrative costs|
|5) Prevalence||More common in the public sector||Commonly adopted in both public and private sectors|
Defined Benefit vs Defined Contribution-FAQs
Is defined benefit better than defined contribution?
The answer to this question depends on individual preferences and financial goals. However, I believe a Defined Contribution plan is better as it gives you the control of your retirement funds. You can determine the deferral amount (although within a set annual limit) and also choose the investment options for your funds which can align with your age and preferences. For instance at a young age you can invest in more aggressive options like stocks and alternative investments (if your plan allows). When you grow older, you can choose to invest in safer options.
Why are defined contribution plans better?
Defined Contribution Plans are considered better by some because they provide employees with greater control over their retirement savings and investment choices. They also offer easier portability and potential tax benefits, making them attractive options for those seeking flexibility and autonomy in managing their retirement funds.
What do defined benefit plan and defined contribution plan have in common?
Both Defined Benefit and Defined Contribution Plans are employer-sponsored retirement plans designed to help employees save for retirement. They aim to provide financial security in the golden years and offer various benefits and advantages, though their fundamental structures and employee involvement differ.
Defined Benefit vs Defined Contribution-Conclusion
In conclusion, choosing between a Defined Benefit Plan and a Defined Contribution Plan depends on individual preferences, risk tolerance, and financial objectives. However, I believe a Defined Contribution plan is better as it gives you the control of your retirement funds.
You can determine the deferral amount (although within a set annual limit) and also choose the investment options for your funds which can align with your age and preferences.
For instance at a young age you can invest in more aggressive options like stocks and alternative investments (if your plan allows). When you grow older, you can choose to invest in safer options.
It is essential to carefully evaluate the features of each plan and consult with financial advisors to make an informed decision that aligns with your long-term retirement goals. Remember, both plans serve the common purpose of ensuring a comfortable and financially secure retirement.