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  • Writer's pictureSamantha Diggs

Explaining the Differences Between Defined Benefit and Defined Contribution Retirement Plans

Employer-sponsored retirement plans are generally divided into two primary categories: defined benefit plans and defined contribution plans, both of which are covered by the Employee Retirement Income Security Act (ERISA). Both types of plans provide a variety of advantages to employees and employers but determining which one is the best fit for any given company requires an understanding of the key differences between these plan categories. Let’s examine these plans in more detail.

Key points of Defined Benefit Plans

Defined Benefit plans guarantee a specific monthly pension benefit for life upon retirement. Most traditional defined benefit plans are protected by federal insurance through the Pension Benefit Guaranty Corporation (PBGC). Defined Benefit plans come in two varieties: Cash Balance Plans and Traditional Pension plans. With the Cash Balance plans, the employees account is credited with a set amount based on the plan’s formula each year. With the pension plan, it is based on the benefit at retirement that is to be achieved. A common formula determines the benefit based upon factors like salary and number of years served at the company. A key element in both of the types of Defined Benefit plans is that individuals can roll the sum of their cash balance plans or their lump sum payout amount from the traditional plan if they have earned the right to the benefit into an IRA if they leave their company before retirement. Employees have very little control over these funds prior to retirement. With these plans, it is the employer who bears the risk because there is no guarantee that the returns on the investments made will cover the amount due to the employee upon retirement. Because of this, administration costs are very high due to the need for accurate actuarial projections to help ensure the plan stays fully funded and the investments stay on track. Defined Benefits plans are highly advantageous to the employees because they can calculate exactly what they will receive upon retirement, and because payments continue for life, based on their election at retirement. However, the high administrative costs and risk posed to the employer have resulted in a sharp decline in the use of Defined Benefit plans as compared to Defined Contribution plans.

Key points of Defined Contribution Plans

Conversely, Defined Contribution plans do not promise specific benefits at retirement. These plans are funded by both the employee and the employer to create a retirement savings nest egg. Like the name suggests, contributions are made at a set (or defined) rate. Upon retirement, employees take whatever funds have accrued. 401(k) plans are the most common type of Defined Contribution plan, but other popular examples include 403(b) plans, profit-sharing plans, and employee stock ownership plans. In most cases it is the employee’s responsibility to make contributions and choose the investments for their funds . Commonly, contributions are invested in mutual funds and money market funds, but they can also include annuities and individual stocks, depending on the specific provisions of the plan. Investments are tax-deferred until funds are withdrawn in retirement. The value of the account fluctuates with the value of the investments, and once the account balance is zeroed out, the benefit is gone forever. Whereas the risk of the account success falls on the plan and the employer with Defined Benefit plans, the employee holds the risk in Defined Contribution plans. Upon retirement, the employee will receive the funds they invested, plus or minus market gains or losses. There are limits to how much employees can contribute to their plan each year. For 2023, the limit is $22,500 or if the participant is age 50 they can add an additional $7,500 catch-up contribution for a total of $30,000.

In Summary

Defined Contribution plans are far more popular with employers than Defined Benefit plans because they are less complicated, less expensive, and relieve the company of the risk. While there are certain industries where Defined Benefit plans (like Cash Balance plans) are well-suited, they are increasingly rare. Defined Contribution plans are popular with employees as well because they maintain control over their investments. Determining which plan is best for your company requires an in-depth evaluation of your specific needs, and the rules and regulations that will apply to your company specifically. It can be difficult to remember all of the distinguishing factors between these two types plans, but the key differences are who funds the plan, who manages the investments, and whether the benefits are pre-determined or subject to market fluctuation. For more information on these plans, or to ask any questions you may have, please contact us! We are always happy to talk retirement plan possibilities with you and see how we can help.

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