When it comes to retirement plans, individuals have many options. For employees, there are some employer-sponsored plans to which they can contribute. Usually, these include defined benefit and defined contribution plans. These are two different retirement plans according to their composition, returns, and management. Before understanding the differences between these, it is crucial to look at each individually.
What is a Defined Benefit Plan?
A defined-benefit plan is a retirement plan in which an employee gets defined benefits. These benefits depend on several factors such as their salary, age, and employment period. In essence, these plans provide a fixed income to the employee that is similar to receiving salaries. Similarly, defined benefit plans are qualified plans, implying that the receiver can get tax benefits under the tax laws.
As mentioned, the benefits that the individual gets depends on several factors. However, there is no specific method for calculating these benefits. Individuals can either take their benefits as a lump-sum amount or an annuity that provides them with payments throughout their life. Pensions and cash balance plans are primary examples of defined benefit plans.
What is a Defined Contribution Plan?
A defined contribution plan is a retirement plan in which an employee makes defined contributions to the scheme. The benefits, on the other hand, are not specific. Instead, the employee receives payments based on how the funds perform, managed by the company or the employer. Like defined-benefit plans, defined contribution plans also come with some tax benefits.
The employer providing this plan specifies the options offered by it and is responsible for organizing it. The employer can also choose to contribute to the scheme. Each employee gets their own pension account. The amount they contribute to the plan depends on their employment contract or terms. 401(k)s and IRAs are examples of defined contribution schemes.
What is the difference between Defined Benefit Plans and Defined Contribution Plans?
There are several differences between defined-benefit and defined-contribution plans. Some of these differences are apparent from the explanation above. Some of the aspects in which defined-benefit and defined-contribution plans differ from each other are as below.
With defined-benefit plans, employees get a predictable income in the future. As mentioned, this income depends on their employment period, age, the formula used, etc. In defined contribution plans, the benefits that employees receive depend on their contributions. It also depends on their employer’s contributions and investment gains or losses.
For most defined-benefit and defined-contribution plans, the contributions come from employees’ pre-tax contributions. Employers may also choose to contribute to these plans. However, for defined-benefit schemes, these will vary according to the plan design or actuarial valuation annually. For defined contribution plans, the contributions are specific.
In a defined-benefit plan, the responsibility of contributing money and managing investments lies with the employer. If the investments perform adversely, the employee is responsible for funding the defined-benefit scheme. In contrast, these responsibilities reside with the employee for defined contribution plans. If the underlying investments perform adversely, employees get lower compensation.
Defined benefit and defined contribution plans are employer-sponsored retirement plans. With defined-benefit plans, employees make varying contributions but get a fixed income. Their income depends on several factors mentioned above. With defined contribution plans, this income varies on how the underlying investments perform. However, the contributions are specific. Both plans also differ according to the responsibilities of employees and employers.