defined benefit plan vs defined contribution plan
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Defining the Benefits
Defining the Benefits - DB vs DC Plans
Employer-sponsored retirement plans generally fall into two broad categories. APERS operates what is known as a “defined benefits” pension plan whereas most private retirement plans are “defined contribution” plans. The basic difference is what each plan promises its participants.
A defined benefit plan (APERS) specifies exactly how much retirement income employees will get once they retire. A defined contribution plan only specifies what each party – the employer and employee – contributes to an employee’s retirement account. Of course, it’s a bit more complicated, so we will examine each type in more detail.
Defined Benefit (APERS)
A defined benefit or “DB” plan, such as the one offered by APERS, guarantees a specific monthly pension based on a formula. In APERS case, when a member retires the formula calculates a monthly payment based on the member’s average salary (highest 3 years), length of service, and a percentage set by law. This payment continues for the life of the retiree. The money comes from the general funds of the plan. The member has no individual retirement account with a fixed amount of money that can be exhausted, so they member cannot outlive his or her retirement funds.
So one of the great advantages of DB plans is their predictability. From the moment employees enter a DB plan, they can calculate exactly what benefits they will receive when retiring under a specific set of circumstances. The longer they work and the higher their salary, the greater their benefit will be, and once it is set it will not change. Of course, the second great advantage is security since the payments continue for life and in some cases beyond if the member chooses a beneficiary option. DB plans like APERS work best on a large scale. They need a high number of contributors to help maintain consistent funding levels, and they require expert statistical analysis to predict trends and guide adjustments. Few private companies possess these resources.
Unlike APERS' DB plan, in a defined contribution or “DC” plan each employee has a separate taxdeferred investment account. The account is funded by contributions from the employee and employer at a rate that is usually spelled out or defined in the employment agreement – hence the name. When employees retire, they take their account with them with whatever assets it has accrued. Although the employer’s contribution is defined, it is impossible to know at any given point how much the account will be worth when the employee retires because the investments in it will be influenced by market forces and other variables beyond the control of employer or employee. The familiar IRA and 401(k) accounts work this way.
DC plan members usually have some control over where and how the funds in their accounts are invested. If the investments perform well, the employee prospers accordingly, but if they don’t then the benefits suffer. Even short-term losses can be significant if they occur when the funds are needed. The amount accrued in the employee’s account at retirement constitutes the whole of the retirement benefits. If the account is ever exhausted, then so are the benefits, and members can outlive their retirement fund.
Stability and Predictability
Any retirement plan will be affected by the general health of the economy and by the performance of the investments that it makes. However, a DB plan removes the risk from the individual and places it on the plan itself. Although APERS members aren’t going to get rich overnight with some clever investment in their retirement account; they’re not going to lose it all in a crash either. They enjoy the security that only a defined benefit can bring.
Article from "APERSpective" Active Members Newsletter - Winter 2019
Defined Benefit vs Defined Contribution (Difference)
Confused between Defined Benefit and Defined Contribution? Find the difference between a Defined Benefit Pension and a Defined Contribution Pension explained.
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Defined Benefit versus Defined Contribution
There is often confusion around the difference between a Defined Benefit and a Defined Contribution pension plan. In this article we explain how Defined Benefit and Defined Contribution pension schemes differ from one another.
Company pensions can generally be categorised as being either defined benefit or defined contribution. A defined benefit pension plan (DB) sets out the specific benefit that will be paid to a retiree. This calculation takes into account factors such as the number of years an employee has worked and their salary, which then dictates the pension and/or lump sum that will be paid on retirement.
A defined contribution pension (DC) is an accumulation of funds that makes up a person's pension pot. A person contributes a portion of their salary to a pension scheme. Ideally, although not always, their employer also contributes and these contributions are invested in a fund in order to provide retirement benefits. There is tax relief on this type of pension and the benefits at retirement will depend on a number of different factors such as the contribution levels, how the investment fund performs, plan charges and fees and the annuity rates available when you retire.
Defined Benefit scheme vs Defined Contribution scheme
The main difference between a defined benefit scheme and a defined contribution scheme is that the former promises a specific income and the latter depends on factors such as the amount you pay into the pension and the fund's investment performance.
When choosing a pension, there are numerous pension plan options available. Whether you are an employer or an employee, an investor or a novice, we have many pensions to choose from which you can see at choosing a pension. Alternatively, our Financial Planning Team can provide you with more information about Zurich's pension plans and options.
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Defined-benefit plans are funded by employers, while employees make contributions to defined-contribution plans to save for retirement.
RETIREMENT PLANNING PENSIONS
Defined-Benefit vs. Defined-Contribution Plan: What's the Difference?
Defined-Benefit vs. Defined-Contribution Plan: What's the Difference? The latter have largely superseded the former
By THE INVESTOPEDIA TEAM Updated March 27, 2022
Reviewed by MARGUERITA CHENG
Fact checked by YARILET PEREZ
Defined-Benefit vs. Defined-Contribution Plan: An Overview
Employer-sponsored retirement plans are divided into two major categories: defined-benefit plans and defined-contribution plans. As the names imply, a defined-benefit plan—also commonly known as a traditional pension plan—provides a specified payment amount in retirement. A defined-contribution plan allows employees and employers (if they choose) to contribute and invest in funds over time to save for retirement.
These key differences determine which party—the employer or employee—bears the investment risks and affects the cost of administration for each plan. Both types of retirement accounts are also known as superannuations.
Employers fund and guarantee a specific retirement benefit amount for each participant of a defined-benefit pension plan.
Defined-contribution plans are funded primarily by the employee, as the participant defers a portion of their gross salary. Employers can match the contributions up to a certain amount if they choose.
A shift to defined-contribution plans has placed the burden of saving and investing for retirement on employees.
The most popular defined-contribution plan is the 401(k).
A steady trend has emerged of companies favoring defined-contribution plans over defined-benefit plans.
Defined-benefit plans provide eligible employees guaranteed income for life when they retire. Employers guarantee a specific retirement benefit amount for each participant that is based on factors such as the employee’s salary and years of service.1
While they are rare in the private sector, defined-benefit pension plans are still somewhat common in the public sector—in particular, in government jobs.
Employees have little control over the funds until they are received in retirement. The company takes responsibility for the investment and for its distribution to the retired employee. That means the employer bears the risk that the returns on the investment will not cover the defined-benefit amount due to a retired employee.2
Because of this risk, defined-benefit plans require complex actuarial projections and insurance for guarantees, making the costs of administration very high. As a result, defined-benefit plans in the private sector are rare and have been largely replaced by defined-contribution plans over the last few decades. The shift to defined-contribution plans has placed the burden of saving and investing for retirement on employees.3
Defined-benefit plans are broken down into two payment options: annuity and lump-sum payments. In an annuity payment plan, the payment is spread out and paid monthly until death. A lump-sum payment is the entire value of the plan paid at one time.
Opting to take defined payments that pay out until death is the more popular choice, as you will not need to manage a large amount of money, and you're less susceptible to market interference.
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Defined Benefit Pension Plan
Defined-contribution plans are funded primarily by the employee. But many employers make matching contributions to a certain amount.1
The most common type of defined-contribution plan is a 401(k). Participants can elect to defer a portion of their gross salary via a pre-tax payroll deduction to the plan, and the company may match the contribution if it chooses, up to a limit it sets.1
As the employer has no obligation toward the account’s performance after the funds are deposited, these plans require little work, are low risk to the employer, and cost less to administer. The employee is responsible for making contributions and choosing investments offered by the plan. Contributions are typically invested in select mutual funds, which contain a basket of stocks or securities, and money market funds, but the investment menu can also include annuities and individual stocks.3
The investments in a defined-contribution plan grow tax-deferred until funds are withdrawn in retirement. There is a limit to how much employees can contribute each year. For 2021, for example, the most an employee could contribute to a 401(k) in one year is $19,500, or $26,000 if they are 50 or older. For 2022, the maximum amount rose to $20,500, or $27,000 if they're 50 or above.4
Those with a define-contribution plan can also contribute to a 403(b). While both the 403(b) and 401(k) are tax-deferred, a 403(b) is much less common as they are restricted to those in non-profit organizations and in government positions. 403(b) plans are often managed by insurance companies and offer fewer investment options when compared to a 401(k). which is often managed by a mutual fund.
Defined-Benefit Plan vs. Defined-Contribution Plan Example
Most private-sector employees are offered and take a defined-contribution plan. They carry less risk for the employer as they are not responsible for managing the account themselves, and offer much more flexibility to the employee.
If John were to contribute to a defined-contribution plan such as the popular 401(k), he would be able to have access to his funds while making his own investment decisions. He could, for example, take an extremely aggressive approach with his investments since he is young and can handle a volatile market. His company offers a 3% match, and he uses it to further invest in his retirement plan.
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