Defined benefit vs. defined contribution pension plans

Written by craig woodman
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Defined benefit vs. defined contribution pension plans
(Ryan McVay/Photodisc/Getty Images)

Defined benefit and defined contribution are the two main types of employer retirement plans. Defined benefit plans were at one time the mainstay of company retirement plans but are not as popular as they used to be. Defined contribution plans are becoming more common, because they are less expensive for employers to administer. Each plan has its advantages for the employer and employee.

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Defined Benefit Plan

A defined-benefit plan, also called a pension, is a plan that pays you a specific amount of money, either per month or in a lump sum, when you become eligible for retirement benefits. These plans usually have formulas to determine how much you receive in benefits based on criteria such as how long you have worked for the company and what your salary is. Generally, the employer pays the complete cost of a defined-benefit plan. Government employment often has a defined-benefit pension plan as one of its benefits.

Defined-Contribution Plan

A defined contribution plan is a plan that does not pay a specific benefit when you retire, but allows you to save money in a tax-deferred account. A 401k is a common type of defined-contribution plan. At retirement, you withdraw this money over time for living expenses. Your employer usually contributes to a defined-contribution plan also, either in the form of a match of some portion of your contributions or a fixed amount.

Advantages

Defined-benefit plans promise a certain payout based on criteria that the participant can control. Generally, if you work at a job longer, you will be able to collect a larger benefit. Many people like the fact that they can easily plan for this, and it takes the mystery out of retirement planning. Defined-contribution plans allow the participant to control how his money is invested. You make the choices depending on how much risk you are willing to tolerate. You can also borrow against a defined-contribution plan in many cases. The money in a defined-contribution plan is also portable and can be moved if you leave your employment. Defined-contribution plans also provide tax benefits, allowing you to defer part of your income and pay taxes on it later after you retire.

Disadvantages

Defined-benefit plans are not as flexible. If you leave employment before a certain time, you could forfeit the pension. The contributions to the pension plan stop when you leave employment, freezing your benefits. Your employer also retains complete control over the fund and determines how it is invested. Defined-contribution plans are not guaranteed to have any particular value when you retire and may gain or lose value depending on investment performance. Where a Defined-benefit plan is generally funded completely by your employer, a defined-contribution plan must be funded, at least in part, by you.

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