Defined Benefit vs. Defined Contribution: Choosing the Right Retirement Program 

By Eddie Vaughn

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 pension plan—promises a specified benefit amount at retirement. The benefit usually is defined via a plan formula based on the employee’s pay and/or years of service and the (guaranteed) benefit is payable for the employee’s lifetime. A defined- contribution plan does not promise a benefit amount at retirement, but rather allows employees and employers (if they choose) to contribute to an individual account and invest funds over time to save for retirement. In this type of plan, it is the annual contribution that is known and the ultimate benefit at retirement depends on the investment performance of the account.

 In general, defined benefit (DB) plans come in two varieties: traditional pensions and cash-balance plans. Examples of defined contribution (DC) plans include 401(k) plans, 403(b) plans, employee stock ownership plans, and profit-sharing plans. The benefits in most defined benefit plans are protected, within certain limitations, by federal insurance provided through the Pension Benefit Guaranty Corporation (PBGC). Defined contribution plans do not have PBGC protection.

Among the key distinctions between DB and DC plans are which party—the employer or employee—bears the investment risks and the cost of administration for each type of plan.

In a DB plan, usually the cost of the plan is borne entirely by the company. Employees are not expected to contribute to the plan, and they do not have individual accounts. Instead of an individual account, the employee has a right to a specific annuity, which is a stream of defined benefit payments. Employees do not have to enroll for the plan, and once they meet basic eligibility rules, they are automatically covered. Except for cash balance plans, benefits in DB plans typically are not as portable when switching jobs as they are under a DC plan.

In a DB plan, the company has responsibility for plan investments and since the benefit promise must be honored regardless of how the underlying funds perform, the employer bears the risk on investments. Because of this risk, DB plans require actuarial computations and insurance that provides for benefit guarantees, making the costs of administration sometimes higher than in some DC plans.

The cost of a DC plan is typically borne by the employees, by deferring a portion of their salary. There are limits on how much an employee can contribute each year, and the employer can match the contributions up to a certain amount, if they choose. The employee often has to enroll in the plan (although auto-enrollment is becoming more popular) and will then have a personal account within the plan to choose investments for. The investments grow on a tax-deferred basis until funds are withdrawn at retirement. The employee owns the account itself and can withdraw or transfer funds according to the provisions of the plan, potentially via loans, hardship distributions, or a distribution upon termination of employment (often in the form of a roll-over to an IRA or their new employers’ plan). Contributions are typically invested in mutual funds and money market funds, but the investment menu can also include annuities and individual stocks. Because the employees’ benefit is the account derived from contributions and earnings thereon, and there is no benefit promise beyond that, the employees bear the investment risk under a DC plan. Aside from offering a satisfactory menu of investment options for the employees to choose from, the employer generally has no obligation or risk with respect to the investments. In addition, these plans generally require less administrative work than DB plans, and will often cost less to administer.

Largely as a result of the factors above, DB plans in the private sector have become less common, increasingly having been replaced by DC plans over the last few decades. This shift to DC plans has placed the burden of saving and investing for retirement on employees.