This post discusses the difference between defined benefit and defined contribution pension plans.

WHAT IS A PENSION?

A pension scheme or system consists of plans, procedures, and legal processes of securing and setting aside funds to meet the social obligation of care employers owe their employees on retirement or in case of death and disability. It is a structured method of providing economic security to individuals who cannot support themselves. A sound pension system ensures that a worker’s benefit is paid appropriately based on the rules of the pension plan. Hence, a pension system guarantees the beneficiaries that the promised benefits are secure and will be paid properly.

DEFINED BENEFIT VS DEFINED CONTRIBUTION PENSION PLANS

The shift towards defined contribution pension plans now puts more of the retirement planning responsibility on the employees’ shoulders, not the employer’s.

DEFINED BENEFIT PENSION PLAN

A defined benefit, also known as Pay As You Go (PAYG) system, the pension plan is a traditional pension. It provides a “defined benefit”- a pre-specified amount or annuity – either in absolute currency or as a fraction of a measure of past earnings and years of employment. The guaranteed pension benefit could be in either natural or nominal terms.

A defined benefit plan is a retirement plan where an employee knows the retirement benefit amount beforehand. In a defined benefit plan, the pension amount is computed by considering the employees’ salary history and the number of years in service. A defined benefit pension system provides a specific and predictable benefit (or amount of income) at retirement. A defined benefit plan is typically not contributory, i.e. an employer is solely responsible for providing pensions to its employees.

Defined benefit plan sponsors may choose from several formulas for determining final retirement benefits, including:

1) Flat-Benefit Formulas: These formulas pay a flat-dollar amount for every year of service recognised under the plan.

2) Career-Average Formulas: There are two types of career-average formulas. Under the first type, participants earn a percentage of the pay recognised for plan purposes each year they plan participants. The second type of career-average formula averages the participant’s yearly earnings throughout the plan participants. The benefit equals a percentage of the career-average pay at retirement, multiplied by the participant’s years of service.

3) Final-Pay Formulas: These plans base benefits on average earnings during a specified number of years at the end of a participant’s career (usually five years), presumably when earnings are highest. The benefit equals a percentage of the participant’s final average earnings multiplied by the years of service. This formula provides the participant with the most significant inflation protection but can represent a higher cost to the employer.

Usually, the formula dictates the defined benefit pension plan and includes the salary, years of service, and the participant’s age. The calculation of specific pension uses may differ slightly, but most look something like this:

2% x Average Yearly Pensionable Earnings During the Highest 5 Years x Years of Pensionable Service.

For example: 2% x $100,000 x 35 Years = $70,000.

With a defined benefit retirement plan, the employer takes on the investment risk and responsibility for ensuring enough investment money to fund the pension payouts. These types of plans often require complex actuarial projections and insurance for guarantees resulting in higher administrative costs.

While defined-benefit pension plans are common; but, they are usually only found within the public sector. The risk of defined benefit pension plans is too much for employers in the private sector, so they opt for other options.

BENEFITS OF DEFINED BENEFIT PENSION PLANS

Employees prefer defined benefit plans, and it is no wonder with the many advantages they provide with minimal risk to the worker.

1) Easier to plan for retirement

2) Flexible retirement dates

3) Flexible payouts

4) Survivor benefits

5) Cost of living adjustments

6) Income splitting

7) The employer bears the risk

8) Portability

9) Younger worker appeal

10) Accountability and transparency

DISADVANTAGES OF DEFINED BENEFIT PENSION PLANS

Although defined benefit retirement plans provide guaranteed income for life, they have some disadvantages for the employee.

1. Working longer than participants needed to.

2. Company-managed fund.

3. Not always indexed to inflation – not all defined benefit plans are indexed to inflation.

4. An employee has no individual pension account.

DEFINED CONTRIBUTION PENSION PLAN

A defined contribution pension plan is one in which the employer and employee contribute. Employers generally promise to make annual or periodic contributions to accounts set up for each employee in a defined contribution plan. Sometimes defined contribution plans are called individual account plans, commonly called Retirement Savings Accounts (RSA). The current contribution is guaranteed but not a level of benefits at retirement, as in a defined benefit plan.

Most defined contribution plans offer some form of contribution that match up to a certain amount. The contribution to a defined contribution plan may be stated as a percentage of the employee’s salary based on the years of service. If an employee contributes 10% of their gross salary, the company may match 50% to $10,000.

Here is what that would look like for an employee with a $100,000 gross salary.

[$100,000 x 10% = $10,000] + [$10,000 x (50% of 10%) = $5,000] = $15,000.

Contributions within a defined contribution pension grow tax-deferred, and there are limits set on annual contributions. These limits include both employee and employer contributions.

BENEFITS OF DEFINED CONTRIBUTION PENSION PLANS

Benefits of a defined contribution pension include:

1. Vested immediately

2. Ability to withdraw or transfer funds

3. Choice of investment options

4. Individual pension account

5. Employer match

DISADVANTAGES OF DEFINED CONTRIBUTION PENSION PLANS

Disadvantages of a defined contribution pension include:

1. Limited funds to choose from

2. Unpredictable retirement income

3. The employee bear’s risk

4. The self-discipline required

CONSIDERATIONS FOR CHOOSING BETWEEN DEFINED BENEFIT AND DEFINED CONTRIBUTION RETIREMENT PLANS

A defined benefit plan specifies how much retirement income employees will get. A defined contribution plan only sets what each party – the employer and employee – contributes to an employee’s retirement account. While a defined benefit plan has become increasingly rare, you may be presented with a choice – either as a new employee or as a longtime employee offered to enrol in a new plan. This is an important decision because it cannot be changed once you decide. 

Here are critical questions to consider if you are to choose between a Defined Benefit and a Defined Contribution Retirement Plan:

1. Which plan could provide you with the most retirement income?

2. Do you prefer stability or flexibility?

3. When do the benefits vest?

See the full video on Defined Benefit and Defined Contribution Pension: https://youtu.be/Shn5Aj05lEU