Defined Benefit plans and Defined Contribution plans can sometimes look similar, but the main difference is what is certain and defined. In a Defined Benefit Plan, your employer guarantees you a certain fixed monthly payment for the rest of your life, so the benefit is said to be defined. A Defined Contribution Plan’s only certainty is the amount that went into the employee account, so the contributions are defined.
Another definition is simply that a Defined Contribution plan has accounts for each employee, while a Defined Benefit plan has one account for all employees.
A Defined Benefit plan will use a formula based on an employee’s salary and years employed to determine the pension payments that are owed to the employee when he or she retires, and the employer’s contribution to pay for that future obligation is calculated based on strict funding guidelines using the guarantees present in the pension fund investment, a conservative future value estimation of any instruments exposed to the market, and any surplus present in the account at the time.
A Defined Contribution plan will sometimes have a match or profit-sharing component which uses the current salary deferrals of the employee or the current profit margin of the business to determine the employer contribution.
Once the contributions go in to a Defined Contribution plan, the future value is anyone’s guess, and the performance of the investments is the responsibility of the employee, who has the ability to pick and choose between at least a few types of investments and to reallocate quarterly.
The investment risk for a Defined Benefit plan is on the shoulders of the employer, but that could also mean that employers get to re-purpose any gains above their obligations as fiduciaries. The amount you save is going to depend on the amount of money you and your employer contribute collectively during your employment (and the performance of your investments).
With a Defined Benefit Plan, the risk rides on the shoulders of the employer and has nothing to do with the recipient. As the names of both plans imply, in a Defined Benefit Plan, your benefits are defined, while in a Defined Contribution Plan, you determine your contributions, and the benefits are not guaranteed.
How are My Retirement Benefits Computed?
Who Offers Defined Benefit Plans?
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