What are Defined Contribution and Defined Benefit Pensions?

If you're researching pensions, you may have encountered the terms 'defined contribution' and 'defined benefit.' But what do they mean, and how do they differ?

Defined Contribution Pensions

In a defined contribution pension plan, the employer, employee, or both make regular contributions to the employee's individual retirement account.

The employee's eventual pension income depends on the total contributions made, as well as how the investments perform.

Since the employer's financial commitment is fixed, the retirement benefits under this plan are variable.

Defined Benefit Pensions

Defined benefit pensions, on the other hand, promise employees a specified monthly benefit upon retirement.

This benefit is based on a specific formula, typically taking into account the employee's salary history and years of service.

The employer bears the investment risk and is responsible for ensuring that there are enough funds to pay the promised benefits.

Key Differences

While both pension types offer retirement benefits, they differ significantly in terms of risk and predictability.

Under a defined contribution plan, the employee bears the investment risk.

In contrast, a defined benefit plan places the investment risk on the employer.

Consequently, the benefit amounts in defined contribution plans fluctuate based on market performance, while defined benefit plans deliver a steady, predictable income.

Regulatory Oversight

Defined benefit plans are often subject to more stringent regulatory oversight compared to defined contribution plans.

The government may require employers offering defined benefit pensions to maintain a certain level of funding to ensure that they can meet their future payment obligations.

Employer Trends

In recent years, there has been a shift away from defined benefit plans in favor of defined contribution plans due to their cost predictability for employers.

However, some employers still offer a combination of both plan types or hybrid options to provide employees with more choices.

Understanding the difference between defined contribution and defined benefit pensions is crucial, especially when considering retirement planning and assessing job offers.

Both plan types have their own advantages and disadvantages, and it's important to carefully evaluate your options and consider seeking professional financial advice.