Defined Benefit vs. Defined Contribution Plans

Published September 29th, 2022
Reading Time: 5 minutes
defined benefit

Written by:

Adam Day, CFP®, CFT-I™
Zoe Network Advisor

Defined Benefit vs. Defined Contribution Plans

Published September 29th, 2022 
Reading Time: 5 minutes
defined benefit

Written by:

Adam Day, CFP®, CFT-I™
Zoe Network Advisor

Retirement plans are implemented to help the employee save and defer funds until a future date, hopefully, retirement. They are also put in place to support the employer save on taxes, and retain talent. You know how it goes, most of what has been around for decades evolves over the years. However, two main categories that remain, are defined benefit plans and defined contribution plans.

Choosing your ideal workplace requires thought and consideration. Building your career and being part of a company has plenty of personal implications! For many, employee benefits can make or break your decision to join a company.

Similarly to car brands, when it comes to retirement benefits through an employer, there are a multitude of options. Plus, regulations are often changing, new models are constantly offered, and sometimes there is a lack of clarity for employees. 

Retirement plans are implemented to help the employee save and defer funds until a future date, hopefully, retirement. They are also put in place to support the employer save on taxes, and retain talent. You know how it goes, most of what has been around for decades evolves over the years. However, two main categories that remain, are defined benefit plans and defined contribution plans. Think of these as the Rolls Royce and Aston Martin of employee benefits, they are classics, but the models have improved over the years, and their benefits differ.  

The Rolls Royce – Defined Benefit Plans

A defined benefit plan is a retirement plan that promises compensation (benefit) at a future date and is defined by specific metrics. The metrics are usually based on a calculation of years of service, age, and a percentage of earnings. When most people hear this, they think of the ‘traditional pension plans’ laid out by many older companies and disregard the option. However, would you ever think a Rolls Royce is outdated? 

The obvious answer should be “no.” A lot of public entities and unions still have these plans in place. The payout is structured as an annuity payment that would last for the retiree’s lifetime and offers some flexibility in design. 

Pros: The biggest pro of a defined benefit plan is that the employee gets a “paycheck” that can last a lifetime. This offers some security as the employer takes on the investment risk. Also, some longevity risks that come with a retirement portfolio, are removed. 

Cons: The risk? Even though most plans are insured and guaranteed by the Pension Benefit Guaranty Corporation, the employer takes on the investment risk. Another downside of defined benefit plans is the lack of flexibility in the payments. There are usually limited options for a large lump sum payout if an emergency or another situation arises. Finally, inflation risk can also result depending on how the payout is structured.  

The interest rate environment and life expectancy has influenced the decrease in popularity of defined benefit plans. Consequently, companies are finding it’s a more significant liability and risk than it used to be. The Rolls Royce will always be as elegant and sophisticated as it has been, however, it will also become more expensive overtime. 

The Aston Martin – Defined Contribution Plan

A defined contribution plan is a retirement plan that establishes the amount that can go into it each year. This is what you would know as your 401(k) plan. The benefit in the future is based on the number of contributions and the investment returns of the account. This payout is structured as either a lump sum, or can be customized distributions to your unique situation. 

Pros: One pro of the defined contribution plan is the flexibility it offers for the employee. There are a lot of options available in the design of these. Sometimes there can be a Roth option, a loan provision, or an early withdrawal option. When the employee has retired or left the company, the money can be rolled over to an individual account or their next company. Bearing the investment risk also allows the employee to grow the account larger than a defined benefit plan would have offered. 

Cons: One of the downsides to defined contribution plans is the flexibility. This plan includes investment risk for the employee as there is also not a mandatory amount that gets contributed, and some employees might not participate.  

Hybrid Cash Balance Plan

As employers move away from the defined benefit plan, there are some key features that owners and employees want to keep. Thus, there is a ‘hybrid’ called a cash balance plan, or in terms of our analogy, the Mercedes-Benz. This plan has a contribution amount defined by an actuarial percentage determined by the plan documents. 

Pros: Annual associated interest credit can be invested in the markets, and the employer bears the market risk. Another advantage of the cash balance plan is that there are more options upon retirement. For example, the employee can take retirement income as an annuity lifetime payout, a lump sum distribution, or even rollover to a qualified retirement plan. 

The Car You Choose Depends on Your Preferences

There are qualities of both the defined benefit and the defined contribution. One pro is that regulations provide much more significant assistance than traditionally defined contribution plans.

All of these options will depend on what your employer has decided to provide. If you have choices between these plans, you’ll want to determine the main differences and decide which is best for your financial planning. For example, do you want to bear the investment risk but have the potential to grow your balance? Then a defined contribution route is the best. On the other hand, do you want the security of a lifetime income stream when you retire? Then a defined benefit plan is the best option. Just remember to analyze the pros and cons and try to fit them into your financial plan. Find a financial advisor that helps you make the best decision for your unique situation. 

Disclosure: This blog is not investment advice and should not be relied on for such advice or as a substitute for consultation with professional accounting, tax, legal or financial advisors. The observations of industry trends should not be read as recommendations for stocks or sectors.

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