Defined Benefit & Defined Contribution Retirement Plans

Jul 1, 2007 by

Over the last twenty years, many Americans have shifted from receiving Defined Benefit retirement plans to Defined Contribution retirement plans. Over the next several entries, I will attempt to explore why this has been done and what it means for those trying to save for retirement.

Defined Benefit Retirement Plans

A defined benefit retirement plan is a plan in which the employee is told the precise amount that he will receive over the course of his retirement. Usually, the employee receives an annuity (either monthly or yearly payment) that is based upon both years of service with the firm and previous salary. Sometimes, the payment level is determined by averaging the salary received over the last three years.

Defined Contribution Retirement Plans

When an employer provides a defined contribution plan, the employer guarantees how much it will contribute to the employee’s retirement fund. However, once the money has been received by the retirement fund, the employer makes no guarantee about how much money the former employee will have in retirement. After the employer provides the employee the pension contribution, the employee must choose how to invest it. Employers will often match the retirement contributions of their employees in order to encourage them to save more. The amount the employee receives in retirement is entirely based upon the size of his contributions, his employer’s contributions, and the soundness of his investment strategy.

Why Defined Contribution Plans Are Becoming More Common

You may have heard about employers converting their defined benefit plans to defined contribution plans. There are multiple reasons why this is occurring. First of all, it is good for the employer, as it eliminates the employer’s long-term risk of having to provide a certain level of benefit. With a defined benefit plan, the employer is responsible for managing the pension and ensuring that it grows rapidly enough for the employee to have his promised benefits. With a defined contribution plan, the employer is not liable for how well the employee’s pension investments perform.

Secondly, defined contribution plans are better for the employee. Once an employer has made a contribution to an employee’s retirement plan, and that contribution has vested, the employee essentially owns that contribution. Thus, it is not possible for a defined contribution plan to be “under-funded.” In the past, many defined benefit pensions were under-funded, as the employer did not put enough money away in savings to be able to afford to pay the promised benefit. In the event of employer default, the employee was stuck receiving what he could from the Pension Benefit Guaranty Corporation, the company that employers are legally required to have insure their pensions. Since defined contribution plans require employers to pay in real-time for their pension obligations, default is not possible.

Finally, defined benefit plans are better in that they allow employees to choose the investment strategy for their pension. Employees have varying preferences for risk, and this can be reflected in their pension investments. With a defined benefit plan, it was not possible for employees to fully customize the investment of their pensions to reflect their preference for risk.

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