Last updated on October 31st, 2019
If you work for a company that offers a retirement plan, you’d be smart to learn as much as you can about how it works. You want to be sure you’re getting as much out of the plan as possible.
Your retirement depends on it.
Employer-sponsored retirement plans can be divided into two main categories: defined benefit vs defined contribution.
In this article we’re going to explain how each type of plan works and give real life examples to give you good understanding of the difference between defined benefit and defined contribution plans.
What is a Defined Benefit Plan?
In a traditional defined benefit pension plan, you would receive a set monthly amount once you reach retirement. The amount you receive would be based on a formula that factors in your length of service with the company, your age at retirement, and your salary.
You’ll continue to receive that amount every month (plus cost of living increases) for the rest of your life.
An example of a defined benefit plan is the one offered by the California State Teachers Retirement System. In their example which you can see here, a teacher who retires at age 63, with 24 years on the job, and whose average monthly income at retirement was $5,500 would receive a monthly benefit of $3,168 upon retirement.
Today, defined benefit plans are practically extinct in the private sector. Most companies that do have a traditional pension plan only keep them open for long-time employees who were grandfathered in.
New hires are typically enrolled into a defined contribution plan instead.
What is a Defined Contribution Plan?
On the other hand, defined contribution plans do not guarantee any specific dollar amount at retirement. Instead, they define the amount of the contribution that goes in.
The most common type of defined contribution plan is the 401(k) plan. If you work for a “for-profit” company that offers a retirement plan it is most likely a 401(k).
Related: Our Ultimate 401(k) Guide will teach you everything you need to know about 401(k) plans.
In very simple terms, a defined contribution works like this:
You contribute a portion of your salary into the account and if you’re lucky your employer will match some or all of those contributions. That’s like free money on top of your salary!
You can invest the money in your account in mutual funds that invest in stocks, bonds, or real estate. The amount you have in your account at retirement depends on:
- how much you contribute
- if your employer also contributes
- how long the money is invested
- the performance of the funds you choose
- fees that eat away at your balance
Here’s a quick chart that summarizes the main differences between defined benefit vs defined contribution retirement plans…
|Defined Benefit||Defined Contribution|
|Funded by your employer||Funded by you, though your employer may offer matching contributions|
|Investment professionals manage the assets for you||You choose where to invest the assets|
|Promises a predictable amount upon |
retirement based on a formula
|No guarantee of a specific amount at retirement|
|Employer bears the investment risk||You bear the investment risk|
The Demise of Defined Benefit Plans
Back in the olden days when our parents and grandparents were working for a living, 401(k) plans and IRA’s had n’t even been invented. Most employees relied solely on their defined benefit pension to support their dreams of retirement.
But until 1974, when the government enacted the Employee Retirement and Income Security Act (ERISA), a company could have a pension plan that wasn’t really backed by anything.
If the company wasn’t profitable or went out of business, the pension would simply disappear and participants would be left empty handed.
It really was like the wild west and without government oversight there were plenty of abuses that dashed the retirement hopes of many Americans.
ERISA required employers to actually fund retirement plans (imagine that!). So even if the company went bankrupt there would still be money to guarantee employee pensions.
This changed everything.
Having to actually spend money to guarantee employee pensions became a significant expense and ate into company profits.
Naturally, employers began to look for ways to shift investment risk from themselves to their employees. Switching from defined benefit to defined contribution retirement plans allowed employers to control their costs and limit their exposure to investment risks.
In today’s world your chances of finding a job that offers a defined benefit pension are pretty much zilch.
And it’s not just the private sector that is affected, government pension plans are also being targeted for reform. As early as 2010, then New Jersey governor Chris Christie was one of the loudest proponents for pension reform:
“I know these reforms will not be popular with everyone,” said Christie. “I also know that failure to follow through with dramatic pension reform will imperil the system for everyone, and that failure to control and share costs of health care benefits will continue to eat away at our state and local budgets. We must reverse the damage caused by fairy tale promises that have fattened benefits and pensions to unsustainable levels while ballooning unfunded liabilities to breathtaking levels.” -source http://njtoday.net/2010/09/15/christie-unveils-pension-reform-plan/
Those are strong words and only time will tell how successful politicians will be in implementing reforms. But I have to give him credit for trying to tackle the issue instead of sweeping it under the rug and leaving it for “the next guy” to worry about.