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Defined Benefit Plans vs. Defined Contribution Plans

Instructor: Dr. Douglas Hawks

Douglas has two master's degrees (MPA & MBA) and is currently working on his PhD in Higher Education Administration.

When it comes to financial planning, retirement is something that everyone, regardless of their age, should consider. In this lesson, we will discuss two types of retirement plans often offered by employers, defined-benefit and defined-contribution plans.

Retirement Strategies

In addition to saving for retirement on their own, many Americans receive retirement benefits from their employers. While there are many different types of retirement plans, according to the IRS, all of them fall into one of two categories. Either employers provide plans that have a defined-benefit or they offer accounts that are funded by defined-contributions.

Over the last twenty years, defined-contributions have become more popular than defined-benefit plans, and we will discuss why a little later. For now, let's just make sure we can define and understand each type of plan.

Defined-Benefit Plans

A defined-benefit plan is a retirement plan that guarantees a certain payout at retirement, based on an employee's years of service and compensation.

For example, John has a defined-benefit plan and will receive 80% of his last year's salary each year of retirement. Since the 'benefit' is the amount of retirement received, it is defined well in advance. His employer Lap of Luxury Furniture, has money invested early on to fund this payment when the time comes.

The factors that determine the benefit may differ from organization to organization, but all are similar in that the future benefit can be defined in advance. These factors may be age, years of service, or compensation at retirement.

Defined-Contribution Plans

A defined-contribution plan is one where the amount saved, or contributed, to a retirement account is defined, but the future value of those deposits is unknown, since they will vary depending on the financial performance of the market.

For example, Extreme Camping Supply may offer to contribute 4% of Rachel's salary into a retirement account. Rachel makes $50,000 per year, so the company is contributing $2,000 per year into a retirement account.

If Rachel is 30 years old and plans to retire when she is 65, that $2,000 may be worth $32,000 in 35 years, or if the market has a horrible 35-year run, it could be worth just $5,000. So, the benefit (again, the amount of retirement received) is not defined - it depends on the financial market. But, the contribution (4% in the example) IS defined.

Differences Between Plans

Besides the obvious differences between these two types of funds, there is another key difference. That is how the benefit (retirement) is funded, and who takes the risk (and reward) of the financial market's performance.

In a defined-benefit plan, the employer is committing to pay an employee a certain amount in the future. The employer funds this by investing money NOW and counting on it increasing in value with the financial market in the future. They'll use that money to pay their employee.

However, if the financial markets don't grow fast enough, the employer still owes the employee that retirement benefit, so they must pay them. That costs the employer more money than they estimated, since their investments didn't grow enough to fund their retirement obligations.

On the other hand, in a defined-contribution plan the employee has the risk (or reward). The employer (and perhaps the employee, if they also contribute) are investing money now and expecting that money to grow in the financial market. If it doesn't, when the employee retires, they may not have enough money.

That's unfortunate, but the employer already paid their part by making the contribution. On the other hand, if the financial market outperforms expectations, the employee will end up with more money than they anticipated. Again, that doesn't impact the employer, since they were just responsible for making the contribution.

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