What’s the Difference Between a Defined Benefit Plan and a Defined Contribution Plan?

Written by , February 11, 2015

What’s the Difference Between a Defined Benefit Plan and a Defined Contribution PlanJust a generation or two ago, the notion of retirement usually involved receiving a regular monthly check from your former employer after having put in 30 or more years of service. Today, individuals usually don’t have access to these types of plans, and instead are responsible for their own retirement planning through 401(k)s and IRAs.

The differences between the traditional employer-provided and today’s individual driven retirement plans can be significant. In general, the biggest difference is that one is essentially a “defined benefit” retirement plan, while the other is a “defined contribution” retirement plan.

Let’s take a look at these differences in greater detail.

  • Defined Benefit Plans Generally. In the broadest terms, a defined benefit retirement plan is one in which a sponsor (usually an individual’s employer) makes promises to provide a specified monthly benefit to the individual once they reach a predetermined retirement age. The amount of the monthly benefit is usually calculated based on multiple factors, including the individuals earning history, the amount of time they worked at the company, and their age at retirement.
  • Types of Defined Benefit Plans. In addition to the less common employer-provided plans, certain types of private annuities and other products offered by some insurance companies may also be considered “defined benefit” retirement plans.
  • Defined Contribution Plans Generally. In contrast, defined contribution plans rely upon the beneficiary to contribute whatever amounts they choose to their retirement account. In some cases these contributions may be matched to some extent by the individual’s employer. The beneficiary has no guarantee of any particular monthly payout or benefit upon retirement, and instead has access to whatever amounts they’ve saved, plus or minus any gains or losses from the investments they’ve made.
  • Types of Defined Contribution Plans. Employer-sponsored 401(k) plans, as well as traditional and Roth IRA accounts, are the most common types of defined contribution plans we see today. There are also similar defined contribution plans for certain categories of public employees, as well as individuals who work for nonprofit organizations.
  • Retirement Planning. Retirement planning with a defined benefit plan versus a defined contribution plan is very different. With a defined benefit plan, you can build your retirement budget with the understanding that you will receive a particular amount each month once you your target retirement age. This can provide many individuals with a high degree of comfort and security. Defined contribution plans do not provide the same predictability, but they may also have a greater upside for individuals who invest wisely and or choose to save more. Individuals who maximize their 401(k) and IRA contributions every year, for example, are more likely to have a significantly larger nest egg when they reach retirement age in individuals who are relying upon a defined benefit plan.
  • Of course, having a defined benefit plan generally does not preclude someone from saving additional amounts towards their retirement. In general, whatever type of plan you have access to, the most important thing is to plan ahead and make regular efforts to save.

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