With these pension plans comes a stable inflow of money which is essential for a person when he is not working. The explanation given will help you know the difference between defined benefit and defined contribution.
Defined Benefit Pension Plan
If defined benefit is your pension plan, then you will get your pension based on your income during your service and the number of years you served your company. Defined benefit pension plans are basically of two types - unfunded plans and funded plans. In unfunded plans, the employer pays the pension benefits to the employees after retirement.
On the other hand, the employer and the plan member's contribution is invested in a fund to meet the financial needs of the employees. The returns received from defined benefit pension plans are not affected with the condition of the stock markets, company's business model or number of years a person lives after retirement, and hence are safe investments.
Defined benefit pension plans are, however, known to be less portable and flexible as compared to the defined contribution plans by some experts. Also, these pension plans do not depend on the employees ability to save as in the case of the defined contribution plans. This plan is an ideal one for people with lower incomes.
Critics also argue that there is lack of transparency about the investment schemes in this kind of pension plan. This pension plan is believed to be suitable more for companies employing many people as compared to smaller firms. Many public sector or government controlled firms adopt this kind of pension strategy for their employees.
Defined Contribution Pension Plan
The defined contribution pension plan works on the principle that employees are given pension as per the assets in their retirement plan account. For making a provision for pension, companies make contributions which are a specific percentage of your salary.
Defined contribution plans have become popular due to the freedom they give employees in choosing the kind of investments to be made from the contributions. So, with this flexibility, every employee will be able to choose investments based on their ability of taking risks.
Many times, employee profit sharing plans are also included in defined contribution pension plans. Since the profits of corporations can fluctuate, the amount which employees will receive will also change. Also, there are popular stock bonus plans in which the employees are given benefits in the form of company's stock.
The money contributed to defined contribution plans is either from employees salary or direct employer payment. However, there are some restrictions on the amount of money that can be contributed and this is governed by the Internal Revenue Service (IRS) section 415 limit guidelines.
For example, in the year 2018, the total contribution limit (employee contribution + employer contribution) has been decided at $55,000. 401(k) and individual retirement accounts are the best examples of defined contribution plans.
Comparing the Two
In case of defined benefit plans, only the employer contributions receive tax advantages, while in the defined contribution plans, both employee and employer contribution get tax benefits.
Risk of Investment
In defined benefit plans, the investment risk is taken by the employer for getting control of investments, whereas in the defined contribution plans, employees take the investment risk for investment rewards.
Termination of Pension Plan
Termination of the pension plan is costly in case of defined benefit plan while in case of defined contribution plans, there are no termination cost issues.
Effect on Retirement
Both plans have an effect on employee retirement. While defined benefit plans encourage early retirement, defined contribution plans encourage employees to increase their professional career span.
In defined benefit plans, employers may handle responsibility of rising inflation, while in defined contribution all inflation risks have to be borne by employees.
Generally, defined benefit plans have automatic enrollment which is mostly absent in defined contribution plans. We conclude that both these pension plans have their own set of advantages and disadvantages. However, these plans have definitely provided much support to employees of various sectors financially.