When you get a job, your employer will hopefully give you some information about the company’s retirement plan. However, you might find yourself seeing terms like “defined benefit” and “defined contribution” and trying to figure out the difference between defined benefit vs. defined contribution retirement plans.
A good retirement plan can be the difference between a relaxing retirement or having to work through your twilight years, so you’ll need to understand these distinctions and consider them carefully. We’ll tell you everything you need to know.
What is a Defined Benefit Plan?
A defined benefit retirement plan is one where the plan outlines the benefits that you’ll receive based on factors such as your earnings, how long you work, and the age at which you retire. In other words, the benefit that you receive when you retire is defined and lined out in the plan documents.
Under a defined benefit program, you don’t have to worry about investing your retirement savings or managing your portfolio. Instead, the organization offering the plan deals with that on your behalf.
Typically, defined benefit plans give retirees two options: a one-time payment when they retire or at a certain age or a regular income from their retirement until they die.
👉 For Example
The best-known type of defined benefit plan is a pension.
If your employer offers a pension, you typically pay a percentage of your salary into the plan. Your employer or a company hired by your employer manages the pension funds and invests them. When you retire, you can use a formula to calculate how much money you’ll receive from the pension each month. It’s up to your employer to make sure they have enough money to make pension payments.
Pensions have grown rare in recent years, but Social Security is quite similar to a defined benefit plan and applies to the vast majority of Americans.
Under Social Security, Americans and their employers pay Social Security taxes. Based on the age at which you start taking benefits and your lifetime earnings, you receive regular Social Security payments from the government until you die.
Defined Benefit Plan Pros and Cons
- You don’t have to manage your portfolio. With a defined benefit plan, your employer handles the investing for you.
- Steady income. Most defined benefit plans offer regular monthly payments.
- Income based on earnings. Most defined benefit plans will base your retirement income in large part on your earnings throughout your career, allowing you to maintain a similar lifestyle in retirement.
- Harder to change employers. Most defined benefit plans will penalize you if you don’t spend a large portion of your career working for that company. If you’re relying on a pension, you’ll have less flexibility to change employers.
- Less flexibility. Defined benefit plans give you a regular source of income, but that means there isn’t a sum of cash to make withdrawals from if you need to. Defined contribution plans, on the other hand, leave you with a nest egg you can tap if needed.
- Risk of company bankruptcy. While defined benefit plans intend to provide a guaranteed retirement income, if your company goes under or mismanages its pension fund, there might not be enough money to go around, which could leave you with little recourse and no monthly income.
What is a Defined Contribution Plan?
A defined contribution is one where the amount of money added to the plan is defined, but there is no guarantee as to how that money will grow or the retirement income it will produce.
With defined contribution plans, you are responsible for deciding how much to contribute to your retirement. You’re also responsible for deciding how that money should be invested. However, when you retire, you have full control over the money in the account and can withdraw it at whatever rate you’d like instead of having to wait for monthly payments.
👉 For Example
The 401(k), one of the most popular retirement accounts in the United States, is probably the best-known defined contribution plan.
Employees can contribute to their 401(k) up to certain annual limits ($19,500 in 2022). Employers can also contribute on their employees’ behalf, typically as matching contributions based on employee saving habits.
When you put money in your 401(k), you can invest it in a variety of securities, such as mutual funds. The money grows tax-free until you reach retirement.
When you retire you can start making withdrawals from the account, as long as you meet age requirements. You can generally withdraw as much or as little as you’d like, but remember that you’re responsible for making the money last. If your 401(k) runs dry, you’ll need to find another way to make ends meet during retirement.
For people looking for a defined contribution plan that’s not provided by an employer, an Individual Retirement Account (IRA) is a good option.
💡 Both 401(k)s and IRAs may be available in traditional and Roth variants. These offer two different types of tax benefits. It’s important to understand the differences between traditional and Roth accounts and consider the benefits of having both types.
Defined Contribution Plan Pros and Cons
- More control. It’s up to you to decide how much to save, how to invest, and how much to withdraw. If you’re a good saver and investor, you could wind up making much more with a defined contribution plan.
- No employer-based risk. The money in your defined contribution plan belongs to you. If your employer goes under, you won’t lose out like someone with a pension might.
- More flexibility. Because you own the money in your 401(k), you can move from employer to employer and won’t lose anything beyond a small amount of unvested employer contributions.
- More responsibility. With a defined contribution plan, it’s all up to you. If you don’t save enough or invest your money poorly, you could find yourself without enough money to retire.
- Vesting schedules. You may have to work for your employer for a fixed number of years to claim your employer’s matching 401(k) contributions. This will not be an issue with an IRA.
- Required minimum distributions. Once you reach 72, you may be required to take distributions from most retirement accounts, which could affect your tax liability.
Defined Benefit vs. Defined Contribution: Which Is Better For You?
The reality is that defined benefit plans are going the way of the dinosaur. According to the Pension Rights Center, only about 31% of Americans have a pension plan from their employer. Unless you work in a few specific industries or for a government, odds are good that you won’t have much of a choice and will have to go with a defined contribution plan.
In general, defined contribution plans work well for people who earn higher amounts and who are good at saving and investing. If you have enough income to save and the discipline to invest well, you could turn a $500 a month retirement contribution into more than $1.5 million over the course of a 40-year career assuming 8% annual returns. That would be enough to support a retirement income of $60,000 or more, which would be a very generous income for a pension.
On the other hand, pensions are great for people who like simplicity. There’s not much simpler than just working for one employer throughout your career, retiring, and still seeing a paycheck come through each month. However, pensions give you less flexibility during and after your career and may give you less income than a well-managed defined contribution plan.
The good news is that most Americans can benefit from both. You’ll likely have access to a 401(k) from your employer and can always open an IRA. Additionally, Social Security will provide most people with a guaranteed retirement income much as a defined contribution plan would.