Defined Contribution Vs Defined Benefit Plan: Each and every man remains anxious about thinking of his life after retirement – What would happen of routine expenses after retirement? To sort out this domestic need, the US government has implemented many social security plans for industrial workers after retirement. Out of these Social Security Plans, Employer-sponsored retirement plans are divided into two categories – Defined benefit plan and Defined Contribution plan.
A Defined-benefit plan is also known as a traditional pension plan which provides guaranteed payments after retirement in the form of a pension, while a defined contribution plan makes a contribution to a retiree account but does not guarantee of a specific amount of returns. Now through this article, we have utmost tried to bring out the difference between these two plans and their associated benefits.
Defined Contribution Vs Defined Benefit Plan
These main difference between these two plans are – 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.
1. Under a Defined-Benefit Pension Plan, the employer gives a guarantee for a specific amount in the form of pension to the participant after retirement and due to this reason, the plan increases its utility significantly and on the other hand, Defined-Contribution Plans are funded primarily by the employee, as the participant defers a portion of their gross salary through its contribution in the investment plans such as – Mutual Funds, Share Market, Company’s own investment plan and many others may be.
No doubt, employers can match the contributions up to a certain amount in the investment plan, chosen by the employee but depend upon the will of the employer only – whether intended to contribute the money or not i.e contribution is not mandatory for the employer.
2. Defined-benefit plan’s costs to the employer too much high due to high administration charges because the employer has to appoint highly qualified professionals and as resultant, employers of the private sector shifted to defined-contribution plans in order to lessen their expenses for the retirement of employees.
Defined-Benefit Plan Detailed Explanations
Defined-benefit plans provide guaranteed income for a lifetime when they retire, as in this plan, employers guarantee a specific retirement benefit amount for each participant which is based on the employee’s salary and length of service.
Defined-benefit plan’s costs to the employer too much high due to high administration charges because the employer has to appoint highly qualified professionals separately for making actuarial projections and insurance for guarantees. Due to high costs, most employers in the private sector replace the defined benefit plan into defined contribution plans after a few decades.
Defined-Contribution Plan Detailed Explanations
In Defined-contribution plans, funded are made primarily by the employee but many employers also do match contribution on a certain amount, as agreed mutually both – employee and the employer.
While comparing to a defined benefit plan, in a defined contribution plan, the pension amount is not known advance. In this plan, the pension amount depends upon the contribution along with the returns generated by your investment.
In a defined contribution plan, you are free to make your decision about choosing the fund manager. The most common type of defined-contribution plan is a 401(k). On choosing the defined contribution plan under 401(k), you defer a portion of their gross salary via a pre-tax payroll deduction and the company may match the contribution if they agreed, up to a limit it sets.
In this plan, it is not obligatory for the employer to look after the account’s performance after the deposition of funds. These plans require little work, low risky to the employer, and also cost less to administer.
The employee is solely responsible for making the contributions and choosing investments offered by the plan. Contributions are generally invested in selected mutual funds, stocks, securities, and money market funds.
The investments in a defined contribution plan are tax-deferred till funds are not withdrawn in retirement. There is a limit to how much amount an employee can contribute each year. Examples: For the year 2020 and 2021, an employee can contribute to a 401(k) in one year is $19,500, or $26,000 if they are 50 or older
Synopsis: At the last, it is advised whether you choose a defined benefit plan or a defined contribution plan, it is necessary to start retirement planning as soon as early possible. Early planning will give more time for your money to grow and gain from the power of compounding in the long run.
No need to hereby suggest to you that a Defined Benefit Plan is better than a Defined Contribution Plan.