Question

What is the difference between a defined benefit and a defined contribution retirement plan? Multiple Choice Defined benefit plans allow employees to set aside money on a tax-exempt basis. Defined contribution plans allow employees to determine a specific amount of money they wish to receive upon retirement. Defined contribution plans allow employees to contribute a set amount toward their retirement plan while employed. Defined benefit plans limit employee contributions while employed.

Answer 1

Defined-Benefit Plan

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.

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.

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 plan over the last few decades. The shift to defined-contribution plans has placed the burden of saving and investing for retirement on employees.

Defined-Contribution Plan

Defined-contribution plans are funded primarily by the employee. But many employers make matching contribution to a certain amount.

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 pretax payroll deduction to the plan, and the company may match the contribution if it chooses, up to a limit it sets.

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 the contributions and choosing investments offered by the plan. Contributions are typically invested in select mutual funds and money market funds, but the investment menu can also include annuities and individual stocks.

The investments in a defined-contribution plan grow tax deferred until funds are withdrawn in retirement.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. In 2020, for example, the most an employee can contribute to a 401(k) is $19,500, or $26,000 if they are 50 or older.

Overview

Employer-sponsored retirement plans are divided into two major categories: defined benefit plan and defined contribution plan. 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 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.