What are defined benefit and defined contribution pension plans?

  • 1
  • Question
  • Updated 7 years ago
  • Answered
Photo of NYCTaxpayer

NYCTaxpayer

  • 303 Posts
  • 0 Reply Likes
  • happy

Posted 7 years ago

  • 1
Photo of FAQ Guru

FAQ Guru, Official Rep

  • 446 Posts
  • 5 Reply Likes
Official Response
A defined benefit pension plan is a type of pension plan in which an employer promises a specified monthly retirement benefit that is predetermined, usually by a formula based on the employee's earnings history, tenure of service and age. The benefit is 'defined' and guaranteed by the employer. Although no funds are set aside separately in an employee-specific account, the employer contributes annually to a pension fund during the employee's working years in order to accumulate enough assets, together with investment returns and the employee’s own contributions, to pay the promised retirement benefits. The employer bears the full risk of the investments - if investment returns are high, the employer contributes less; and if investment returns are low, the employer contributions increase to compensate. The employer's contribution may vary from year to year, sometimes significantly, depending on a variety of factors, including the amount of investment returns earned.

A defined contribution pension plan is a type of retirement plan in which the employer annually contributes a predetermined amount (usually expressed as a percentage of compensation earned by the employee) into an individual account set up for the employee. This account accumulates the employer contributions, the investment earnings, and, if applicable, the employee contributions. The funds are invested, at the direction of the employee, usually in any combination among a variety of approved investments. The employee bears the entire investment risk - if investment returns are high, the balance in the fund increases and allows the individual to enjoy a higher retirement benefit; if they are low, the retirement benefit will necessarily be lowered. After retirement, an individual withdraws amounts (it is not always at their discretion at age 70.5 paricipants are required to take required minimum distributions) from his/her individual accumulated account to provide retirement income. The individual is responsible for making all decisions, including how much to withdraw each month or year and making this income last his lifetime, if he so desires. In some plans, the individual is able to buy a "life annuity," based on the balance in the fund, that provides a lifetime fixed income. In a defined contributions plan, the employer's annual contributions are always predictable and stable, as the employer bears no risk or responsibility beyond making the specified annual contributions into the employee’s account during the employee's working years.