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Defined Benefit Retirement Plan vs. Defined Contribution Retirement Plan

Updated on December 25, 2010

Defined Benefit Retirement Plan vs. Defined Contribution Retirement Plan

Retirement is a subject that is certainly important to members of the workforce as well as the businesses that employ those members of the workforce. For the employer, having a good retirement benefits program can be the difference between attracting and retaining qualified and motivated employees and not having the ability to do so. Many employees consider an employer’s retirement program when making decision concerning working for or remaining with the employer. Two types of retirement plans that many organizations offer are the defined benefit plan and the defined contribution retirement plan. Both programs have aspects that may be desirable to potential employees.

A defined benefit plan is a company retirement plan in which a retired employee amount based on salary history and years of service, and in which the employer bears the investment risk. Contributions may be made by the employee, the employer, or both. A defined contribution retirement plan is company retirement plan employee elects to defer some amount of his or her salary into the plan bears the investment risk. The major difference between the two programs is that with a defined benefit plan, the employer bears the investment risk and with a defined contribution retirement plan, the employee bears the investment risk. receives a specific in which the and

Dynamics of the Defined Benefit Plan

With a defined benefit plan, there is more risk for the employer because the employer bears the investment risk. An example of a defined benefit plan is a defined benefit pension plan. It is the legal obligation of the employee to cover any financial deficiencies with this type of program so the employee essentially bears no investment risk. It is also the employer’s responsibility to make the investment contributions on behalf of the employee, so any investment decisions related to this type of program is the responsibility of the employer. In regards to the size of the of the retirement benefit ultimately received by the retiree, a study showed that defined benefit plan participants fared better than their defined contribution counterparts. Ten years after retirement, a defined benefit retirement plan participant with thirty years of service, who had an average annual salary of $30,000, received about $16,797 each year.

Dynamics of the Defined Contribution Retirement Plan

With a defined contribution retirement plan, the investment risks as well as the investment decisions are placed on the employee. An example of a defined contribution retirement plan is a 401(k) plan. In the same study mentioned above in reference to the comparison between the two plans, the study found that ten years after retirement, a retiree with thirty years of service who had an average annual salary of $30,000 received about $11,230 each year from a defined contribution retirement plan.

The Defined Benefit Pension Plan: An Example of a Defined Benefit Retirement Plan

Key features of a pension plan are:

  1. Employer makes contributions as set by plan terms
  2. May vest over time according to plan terms
  3. Must be offered to all employees at least 21 years of age who worked at least 1,000 hours in previous year.
  4. Up to a maximum of 15% of salary or a maximum of $30,000 for annual contribution.
  5. May permit loans and hardship withdrawals. Hardship withdrawals may be subject to a possible 10% penalty if participant is under age 59 1/2. Payment of benefits is generally made at retirement.
  6. Employer contribution level can be determined year to year.

The 401(k): An Example of a Defined Contribution Retirement Plan

The key features of a pension 401(k) plan are:

  1. Can be provided by any business with 100 or fewer employees that does not currently maintain any other retirement plan.
  2. Can be funded by employee salary reduction contributions and/or employer contributions.
  3. Can be funded by both the employee and the employer. The employee can contribute $6,000 per year. The employer can either match employee contributions dollar for dollar up to 3% of compensation or contribute 2% of each eligible employee's compensation, up to $3,200.All employees who have earned at least $5,000 in previous 2 years are eligible.
  4. Withdrawals at any time. If employee is under age 59 1/2, may be subject to a 25% penalty if taken within the first 2 years of participation and a possible 10% penalty if taken afterwards.
  5. Employee and employer contributions are vested 100% immediately.
  6. Employee can decide how much to contribute. Employer must make matching contributions or contribute 2% of each employee's salary up to the set maximum.

In my opinion, the defined benefit plan would be preferable because will allow the employee to build funds for retirement with very little risk. It will also take the responsibility of making the investment decisions out of the employee’s hands which is preferable if they have little investment experience. The risk involved with the defined contribution plan as well as the requirement to make their own investment decisions might make it a less attractive choice for some employees.

Organizations may favor one plan over the other depending on the number of employees the organization employs. The tax advantages associated with the benefit plans may also cause an organization to favor one over the other. Also, the costs of the plans may cause employers to favor on plan over the other. Employers using defined contribution plans incur can incur fewer costs than employers using defined benefit plans.

The overwhelming majority of all new plans are defined contribution retirement plans because it is cheaper for employers to offer them in comparison to defined benefit plans. The defined contribution retirement plan also shifts investment performance liability from the employer to the employee.

Explanation of Defined Benefit Retirement Plans and Defined Contribution Retirement Plans


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