What are defined benefit and defined contribution pension plans?
March 27, 2010
There are two most common types of pension plans: defined-contribution and defined-benefit plans. Some companies use profit sharing pension plans and hybrid retirement plans as well (e.g. cash balance, target benefit plans). However, the majority of U.S. employers in the private sector prefer defined-contributions plans because:
- Under the defined-contribution plan investment risk is assumed by employees, and
- They cost a smaller percentage (e.g. less than 3%) of payroll expenses in comparison to defined-benefit plans (e.g. 5-6%).
Defined-contribution pension plans only define the amount of contribution the employer has to make to the plan. In other words, the employer must only contribute a certain amount to the plan each period. The amount of employer's contribution is based on a formula, which includes such factors as employee's age, years of service, salary levels, and employer's revenues. Define-contribution plans, however, do not specify nor make a promise about the benefits pension recipients (herein called employees), covered by the plan, will ultimately receive in the future. Instead, the employer hires an independent third-party trustee (i.e. pension trust) to manage the employer's contributions, to make investments, and to make distributions to the beneficiaries of the plan (i.e. employees). Important to note that the trust is an entity separate from the employer, and employees are the only "beneficiaries" of the trust; that is, both investment rewards (benefits) and risks (losses) are assumed by employees.
The benefits an employee can receive under a defined-contribution plan depend on the following factors:
- The original amount of employer's contribution
- Income accumulated by the trust from its investments (e.g. in stocks, bonds)
- Forfeitures of funds due to the early terminations of some employees
Some defined-contribution plans offer additional benefits to employees. For instance, under certain plans employers have to match a portion of the employee's contribution to the plan (i.e. employers have to contribute an additional amount that equals a certain percentage of the employee's contribution). In such a case, employees usually cannot withdraw their funds, without incurring a substantial penalty fee, until they reach a certain age (e.g. 59.5 years).
In the Unites States, the examples of defined-contribution plans are 401(k) plans, 403(b), and IRAs (Individual Retirement Account).