Learn about investing, trading, retirement, banking, personal finance and more.
In the broad landscape of retirement planning, two distinctive types of plans come into play – Defined Benefit Plans and Defined Contribution Plans. This differentiation essentially revolves around who assumes the investment risks, who funds the plan, and how administration costs are managed. Both types of plans are often referred to as superannuations.
Key Players Behind Defined Benefit Plans
Historically, behemoth corporations such as General Electric and General Motors were amongst the prime facilitators of Defined Benefit Plans. However, the long-term burden of guaranteeing the performance of these plans resulted in a significant strain on their profitability. If the plan failed to perform as per assumptions, the corporations had to shell out the difference from their profits. As a result, most companies today prefer Defined Contribution Plans, which shift the burden of performance to employees, over Defined Benefit Plans.
That said, Defined Benefit Plans haven't entirely disappeared from the retirement planning landscape. Some key players still offer these plans, particularly within union groups. Collective bargaining has been leveraged to establish Defined Benefit Plans across multiple employers. These multi-employer pensions, especially union arrangements, have however faced substantial challenges to remain fully funded up to actuarial standards in recent decades.
The Trade-offs Between Defined Benefit and Defined Contribution Plans
Defined Benefit Plans, financed primarily by employers, promise a specific retirement benefit amount for each participant. In contrast, Defined Contribution Plans are largely funded by employees. They defer a portion of their gross salary into these plans, and employers can opt to match the contributions up to a certain amount. The 401(k), a popular example of a Defined Contribution Plan, signifies the noticeable shift of companies favoring these plans over their defined benefit counterparts.
The trade-off here lies in who shoulders the investment risks. While employers bear the brunt of investment risks in Defined Benefit Plans, employees bear this burden in Defined Contribution Plans. This shift of risk from employer to employee is why individuals must be informed and active participants in their retirement planning.
Advice for Smaller Businesses and Low-profit Entities
An essential point to consider is that not every organization is suitable for providing Defined Benefit Plans. Particularly for smaller businesses or those with a slim profit margin, setting up a Defined Benefit Plan might not be a viable option. These plans carry higher administrative costs compared to other retirement plans, and when underfunded, can trigger excise tax. Thus, for businesses with limited resources, adopting Defined Contribution Plans is a more feasible path toward retirement planning.
While Defined Benefit Plans have dwindled in popularity due to their high-cost nature and investment risks, they are still being offered by union groups and some large corporations. Nevertheless, with the increasing favorability of Defined Contribution Plans, employees are now taking a more front-seat role in their retirement planning.
Summary:
Any employer can offer a Defined Benefit plan, but not many do anymore.
Before the introduction of Defined Contribution Plans, most large corporations such as General Electric, General Motors, etc. offered only Defined Benefit Plans. Over the years, it has put a huge burden on these corporations to guarantee the performance of these plans.
If the plan has not performed according to the assumptions, the company would have to contribute the difference, which would have to come from their profits. In order to shift the burden to the employees, most companies now offer Defined Contribution Plans (such as 401(k)s, etc.) instead of Defined Benefit Plans.
The plan participant bears the investment risk in defined contribution plans. This is why it has become so important for you to be an informed and active participant in your retirement planning.
See our articles about defined contribution plans for more details (located in the ‘Retirement Accounts’ section).
Pensions have always been popular with union groups, and they use collective bargaining to set up plans across multiple employers. Many pensions, especially multi-employer pensions such as union arrangements, have struggled to remain fully-funded up to actuarial standards in the last decade or two.
Businesses which are not very large or who do not have a significant profit margin should not attempt to use a defined benefit plan. An excise tax will apply when the plan Is underfunded, and the administrative costs of defined benefits plans are higher than any other form of retirement plan. (IRS information on Excise Taxes — found here)
How Does a 401(k) Compare With Other Retirement Plans?
How Do I Allocate My Assets in Retirement?
Long-term debt refers to the duration of a liability/amount owed, and to qualify it must be due at least 12 months out
Explore the concept of the discount rate, its role in Federal Reserve's monetary policy, and its application in Discounted Cash Flow (DCF) analysis. Learn how it influences the economy, investment valuation, and more. A must-read for investors and financial professionals.
Social Security uses mandatory payroll taxes to grow trust funds that are used to pay income to retirees (qualified ppl)
Explore the Wilshire 5000 Index, a market capitalization-weighted index reflecting the performance of almost all publicly traded U.S. corporations. Learn how it's calculated, its role as a benchmark for U.S. equity markets, and its benefits and limitations for investors.
Discover the importance of the Price/Earnings to Growth (PEG) Ratio in evaluating a company's stock value relative to its expected growth. Learn how to calculate the PEG ratio and its role in making informed investment decisions.
Unravel the complex economic phenomenon of stagflation, marked by slow growth, high unemployment, and inflation. Understand its causes, from oil price shocks to poor economic policies, and its implications for individuals and businesses. Learn strategies to effectively address stagflation.
The Ascending Triangle pattern has a horizontal top line representing a resistance level, and an upward-sloping bottom
Explore the Korean Composite Stock Price Indexes (KOSPI) - South Korea's financial heartbeat. From its origins to its composition, delve into the significance of KOSPI, its variants, and investment avenues. A comprehensive guide to understanding South Korea's stock market landscape
Irrevocable Trusts: A comprehensive guide to understanding the benefits of these powerful estate planning tools. Explore asset protection, estate tax reduction, and securing financial legacies with irrevocable trusts. Learn about the various types and their versatile applications...
Norwegian cruise line vs Carnival: Explore our in-depth financial analysis comparing Carnival Corp (CCL) and Norwegian Cruise Line (NCLH). Discover which cruise stock could anchor your portfolio for long-term gains and short-term trends. Dive into market positions, financial health