Understanding Defined Benefit and Defined Contribution Plans

Julia Carlson |
Categories
Pension
Financial Planning
Retirement

When planning for retirement, it is helpful to know the difference between a Defined Benefit (DB) and Defined Contribution (DC) plan. Here is a look at the two types of plans and what your employer may offer.

What is a Defined Benefit plan?

A Defined Benefit Plan is a retirement plan sponsored by an employer that promises a specific benefit upon retirement. This is typically based on factors such as salary and years of service, which means that employees can anticipate a predictable income stream in retirement, regardless of investment performance. Key Advantages of Defined Benefit Plans:

  • Guaranteed income: Employees receive ongoing retirement income for life.
  • Employer-funded: The employer bears the investment risk, reducing the burden on the employee.
  • Potential for spousal and survivor benefits: Many DB plans offer benefits to spouses and dependents.
  • Government insured: The benefits are protected, within limitations, by federal insurance provided by the Pension Benefit Guaranty Corporation.

Key Disadvantages of Defined Benefit Plans:

  • Portability issues: DB plans are often tied to a specific employer, making them less portable when changing jobs.
  • Not inflation protected: Most DB plans have a set monthly payout that does not increase with inflation.
  • Potential for plan termination: If a company faces financial difficulties, it may be forced to terminate its DB plan.
  • Limited investment control: Employees have little or no control over how their pension funds are invested.

What is a Defined Contribution plan?

A Defined Contribution plan, such as a 401(k) or IRA, involves the employee contributing a portion of their income to a retirement account. The growth of these accounts depends on investment performance and employee contributions. Employers may also match contributions in certain plans.

Key Advantages of Defined Contribution Plans:

  • Flexibility: Employees have more control over their investments and can generally choose from a variety of investment options.
  • Portability: DC plans are typically portable, allowing employees to roll over funds to new accounts when changing jobs or retiring.
  • Tax advantages: Contributions to DC plans may be tax-deductible. Key Disadvantages of Defined Contribution Plans:
  • Investment risk: The success of a DC plan depends on the performance of the investments, which can fluctuate.
  • Limited income potential: DC plans generally do not provide a guaranteed income stream.

Now that you know the difference between the two, you can use this information to better understand your unique situation. It is recommended to consult with a financial advisor to maximize the benefit of your retirement plan. If you need help navigating your retirement plans, give us a call.

Information in this material is for general information only and not intended as investment, tax, or legal advice. Please consult the appropriate professionals for specific information regarding your individual situation prior to making any financial decision.

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