Understanding workplace retirement plans: Defined contribution and Defined benefit Plans

Defined contribution plans and defined benefit plans have a number of notable differences. In a defined contribution plan, both you and your employer can contribute to your individual account. For some plans, you may be required to wait up to one year before enrolling.

There may also be a waiting period before any contributions your employer makes to the account become yours to keep.

In a defined benefit plan, generally, only your employer contributes and you get a monthly payout in retirement. There are two types of defined benefit plans: traditional pensions and cash-balance plans. Both plans automatically enroll participants. However, for some defined benefit plans, you must wait some period of time before you are enrolled and/or the benefits become yours to keep.

retirement plans

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

Defined-Contribution Plan

Defined-contribution plans are funded primarily by the employee. But many employers make matching contributions 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 pre-tax 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 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.

How do these workplace retirement plans work?

Employees invest in defined contribution plans to supplement their future Social Security benefits, as Social Security alone may not be enough to pay for retirement.

As an employee, you decide how much you want to contribute to your individual account. Your contributions are deducted from your paycheck and added to your account automatically. Many employers offer matching contributions. If you contribute a dollar, your employer may add a portion of a dollar in return, up to a certain percentage of your salary (usually 3-6%, though these percentages may vary).

Currently, the maximum amount an employee can contribute to a plan is $19,500 per year. If you are age 50 or older, you can add up to an additional $6,500, for a total of $26,000 per year (known as catch-up contributions). The IRS lists current contribution limits for various plans.

You can then choose how you want your money invested. Most plans offer several investment choices, and each has its own fee structure and risk profile.

You can start withdrawing funds from your account at age 59½. If you withdraw before then, generally you’ll face a 10% early withdrawal penalty. Many defined contribution plans also offer tax benefits. For example, in a 401(k) plan, your contributions are in pretax dollars; they grow tax-deferred until you withdraw the money.

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 overtime 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.

Understanding workplace retirement plans

Limitations of Defined-Contribution Plans

Defined-contribution plans, like a 401(k) account, require employees to invest and manage their own money in order to save up enough for retirement income later in life. Employees may not be financially savvy and perhaps have no other experience investing in stocks, bonds, and other asset classes. This means that some individuals may invest in improper portfolios, for instance, over-investing in their own company’s stock rather than a well-diversified portfolio of various asset class indices.

Defined-benefit (DB) pension plans, in contrast to DC plans, are professionally managed and guarantee retirement income for life from the employer as an annuity. DC plans have no such guarantees, and many workers, even if they have a well-diversified portfolio, are not putting enough away on a regular basis, and so will find that they do not have enough funds to last through retirement.

Defined Benefit Plan vs. Defined Contribution Plan

Defined contribution plans work very differently than defined benefit plans. Where a defined contribution plan puts most of the responsibility for contributing money and managing investments on the employee, a defined benefit plan places these responsibilities on the employer.

A defined benefit plan guarantees a specific amount of money employees can expect to receive as income each month in retirement, whether that’s an exact dollar amount or a percent of salary averaged over particular earning years.

The defined benefit plan you’re probably most familiar with is a traditional pension plan. Generally, employers make the bulk of contributions to a traditional pension plan, rather than the employee.

Pension plans used to be common in the workplace—at one point, the vast majority of private-sector workers had one. Today, only 21% of workers participate in a pension plan, and they’re largely state and local government workers. Twice as many workers (43%) participate in a defined contribution plan.

Defined contribution plans are largely funded by employee contributions, and they offer no guaranteed return of income in retirement. Unlike defined benefit plans, however, they generally offer the employee control over investments made with the plan contributions.

Defined contribution and Defined benefit Plans

Considerations for investing in a workplace retirement plan

  • Consider making regular contributions to your individual account, up to the plan limit.
  • Determine whether you want to make your contributions on a pre-tax basis or after taxes using a Roth account.
  • Look into whether your employer provides matching contributions and consider taking advantage of your employer’s matching contribution to the fullest.
  • You’ll be given different choices regarding how your money will be invested. If you have any questions about which investment option might be best for you, consult a financial advisor.

Overview

IAS 26 Accounting and Reporting by Retirement Benefit Plans outlines the requirements for the preparation of financial statements of retirement benefit plans. It outlines the financial statements required and discusses the measurement of various line items, particularly the actuarial present value of promised retirement benefits for defined benefit plans.

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