Defined Benefit Plan vs. Defined Contribution Plan
Both pension plans and retirement plans provide financial benefits after you reach retirement age. The basic difference is that pension plans provide a defined benefit, and are thus known as defined benefit plans, while retirement plans provide a benefit that depends on the amount of your contributions plus investment returns on the contributions, and are thus known as defined contribution plans. There are other differences between these plans which may impact your retirement.
Amount of Benefit
As mentioned above, pension plans provide a defined benefit once you reach retirement age. The specific amount is usually determined by a formula that includes the number of years you work for an employer and your average salary over a certain number of years (e.g., three). For example, a teacher working for a school district that offers a pension plan may receive a pension benefit equal to 2% multiplied by her average salary during her last three years of work multiplied by the number of years she worked. If her average salary was $50,000 per year and she worked for 25 years, then her pension benefit will equal $25,000 per year. In contrast, retirement plans provide a benefit that depends on the amount of contributions, plus (or minus) any investment returns on the contributions. In some cases, the contributions also include a matching amount from an employer. For example, many employers will match 50% of their employees’ contributions up to 6% of their salary.
In times of prosperity, retirement plans have the potential to provide higher benefits than pension plans. For example, during the prosperous 1990s, many people preferred retirement plans to pension plans due to the robust stock market. But in recessionary or slow-growth economic times, pension plans often provide benefits that beat retirement plans due to poor stock-market performance.
Another difference between pension and retirement plans involves the allocation of investment risk. In pension plans, the employer bears the risk of the pension’s assets earning enough of an investment return to pay the defined benefits promised to its employees. If the assets fall short, the employer will be forced to contribute more funds to the pension plan. In contrast, in retirement plans, the owner of the plan must decide how to invest her contributions and thus bears the investment risk. If the investments do not perform well, then the owner will simply receive lower benefits at retirement.
The allocation of investment risk has been a major reason why employers have been eliminating and/or freezing their pension plans over the last decade. The stock market’s poor performance during that period has resulted in pension shortfalls that have forced many companies to make large pension plan contributions. To avoid the need for such payments in the future, companies have been eliminating or freezing their pension plans and shifting their employees to retirement plans in order to shift this risk.
Most pension plans are funded primarily by employers, although some employees contribute a small percentage of their salaries. In contrast, retirement plans are funded by their owners, although some employers match a portion of their employees’ contributions in employer-sponsored plans. While investment returns on pension plan assets reduce the amount of funding needed from employers, the poor financial market performance in the last decade has accelerated the shift away from pension plans.
Pension and retirement plans also differ in their vesting requirements. Vesting refers to an employee’s right to the assets in her account. It usually takes many years for an employee to become vested in a pension plan, other than any pension contributions the employee may make. In contrast, the owners of retirement plans are immediately invested in their own contributions, and usually vest in any matching contributions at a set schedule, such as vesting 20% of these matching funds each year.
Link to Employment
Pension plans are always linked to employment. You work for an employer which offers a pension plan to its employees, or you have no pension. You cannot, as an individual, fund your own pension plan. In contrast, anyone can have a retirement plan, which may or may not be linked to your employer. For example, an employee can have a retirement plan sponsored by her employer while also owning one or more Individual Retirement Accounts (IRAs) that are independent of her employer.
The ability to own retirement plans independent of employment is a big advantage of retirement plans. This feature means an employee can move from one employer to another without losing her retirement benefits. In contrast, an employee moving from one employer to another employer may lose her entire pension account with her old employer, unless she’s vested, which may result in a huge financial hit.
An important difference between pension and retirement plans involves who manages the investments. With a pension plan, an investment professional manages the assets. Thus, pension plans are managed by skilled investors who are experts at making investment decisions. In contrast, with a retirement plan, the owner decides how to invest her assets. Thus, in the majority of cases, retirement plans are managed by laypeople with little or no knowledge of financial matters. The ability to hire investment professionals to manage pension plans is a big advantage of pension plans.
Pension and retirement plans offer similar distribution options. Pension plan distributions usually involve the payment of a monthly benefit after retirement, although some plans offer the option of receiving a lump sum payment which can be rolled into an IRA. Retirement plans often offer greater flexibility, although it is common for owners to withdraw a monthly amount after retirement, or to purchase an annuity which will pay them a monthly benefit for the rest of their life.