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

Having access to a pension plan through your employer is an incredible foundation to build your retirement plan upon.

There are two variations of Pension plans.

1. Defined Benefit plans

2. Defined Contribution plans

Defined Benefit Pension Plans

A Defined Benefit (DB) pension plan provides employees with a guaranteed income during retirement. Typically, a DB pension is funded equally between employee and employer contributions. How much a retired employee will receive each month is determined by several factors;

• Number of years the employee worked for the company
• The employee's career earnings
• The percentage of income the DB plan aims to replace

It’s probably easiest to demonstrate how a DB plan works with an example.

Let’s say you worked for a company that provided a DB plan that aimed to replace 2% of your average salary for each year you worked at the company.

Let's also assume that you worked at this company for 30 years and during that time your average annual income was $50,000.

How much would you expect the pension to pay you each year in retirement?

$50,000 X (2% X 30) = $50,000 X 60%= $30,000

Based off what we know about this DB plan you would expect to bring in $30,000 in retirement income.

DB plans are designed to be more generous the longer you work at the company. In the above example, if you had worked at the company for 40 years rather than 30, your annual pension income would increase from $30,000 to $40,000.

In this way, DB plans are often used as a tool to retain employees as there is a significant opportunity cost for leaving the pension plan early.

Defined Contribution Pension Plans

A Defined Contribution (DC) pension plan does not provide employees with a guaranteed income during retirement. Instead, it guarantees that the employer will match the contributions made by an employee (up to a threshold).

After the employee and employer contributions have been made it is up to the employee to invest those funds. A 401(k) is the most common form of DC pension plans today.

Let’s say you work for a company that offers a DC plan that requires you to contribute 5% of your salary, which the employer matches. If we assume that your career average earnings are once again $50,000 between your contributions and your employer contributions an average of $5,000 is contributed to your pension.

If $5,000 was contributed to your pension each year for 30 years, how much money would you have when you retire? The answer depends largely on how your investments perform over that time.

If your average annual investment return was 3% you would have $245,000 upon retirement

If your average annual investment return was 6% you would have $419,000 upon retirement.

Which is Better?

DC pensions and 401(k)’s are fantastic tools to build wealth over the long term. They are much more flexible and portable than DB pensions.

Most people, however, will be better off under a DB pension plan. The reason is that a DB pension plan only requires the employee to make one decision, the date they wish to retire.

DC plans and 401(k)’s, on the other hand, require employees to make constant decisions that have serious implications for their retirement.

• First, many DC plans and 401(k) require the employee to choose to opt in to the plan. Many employees fail to do so as soon as possible which reduces their income during retirement. Whereas many DB plans have a mandatory enrollment.
• Second, under a DC plan, the employee must make all the investment decisions. Since our human brains tend to make bad investment decisions, most people tend to invest aggressively when they should be cautious and cautious when they should be aggressive. Under a DB plan, the employee has no control over how the money is invested.
• Third, when it is time to retire employees under a DC plan must decide how to live off their retirement nest egg. The now-retired employee must decide how to ensure their nest egg can fund their retirement while at the same time ensuring they do not outlive their money. The retired employee under the DB plan does not have to worry about such things, they know exactly how much income they will have during retirement.

In most cases, a DB plan is superior to a DC plan because it provides the employee with fewer chances to screw up or put off these very complex and important decisions.

That Being Said…

There are some people who may be better off under a DC plan. That would be people who are knowledgeable and disciplined enough to make the decisions required under a DC pension. If someone is comfortable investing their own money and knows how to live off their retirement nest egg without running out, they may prefer the flexibility and freedoms provided by a DC plan.

Personally, I have a Defined Benefit pension at my job. I am very grateful for this because I am among a minority of private-sector employees with a defined benefit pension. However, given the low-interest-rate environment, we find ourselves in, my pension has become quite expensive as the contributions required to fund the plan have increased significantly over the years.

As someone who is comfortable investing my own money there are days, I wish I could switch into a DC rather than a DB pension plan. I would file that under “good problems to have”.

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This article is for informational purposes only, it should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any major financial decisions