Defined benefit vs defined contribution pension plans
Quite often personal finance becomes synonymous to retirement. And it is no surprise. Retirement, with longer life expectancy and active retirement lifestyles, is a significant part of a personal financial plan. Funds in retirement can come from many different sources, and employer-sponsored pension plans are some of them.
In the past, many employers offered life-time employment and defined benefit pension plans to their employees. Just as you can guess from its name, a beneficiary of a defined benefit plan is guaranteed a certain level of income in retirement. This income is usually expressed as a percentage of some kind of salary base (e.g. best 3 years, or last three years). In other words, employer assumes all risks related to the performance of the funds, and how long the income needs to be received within a defined benefit plan. Defined benefit plans are expensive and risky for the employers, so it is not surprising that it is quite rare for a new employee these days to be given access to a defined benefit plans.
As companies moved away from defined benefit plans, they started offering defined contribution plans as a part of their benefit packages. The risks of the performance of the funds, or the length of the payment period in defined contribution plans are moved on to the employee. It is up to the employee to decide how to invest their contributions and the employer guarantees just that — contributions, usually expressed as a percentage of salary.
Employers usually also offer a match, i.e. contribution of extra funds to the employee’s plan provided that the employee contributes a percentage of their salary. There a different schools of thought about how much should one contribute to an employee-sponsored plan. Usually there is not much flexibility and narrow choice of investment options under the employee-sponsored plans, so it may be advisable to contribute to achieve the maximum match from the employee and invest any extra available funds independently.
For example, the employer has a 4%+4%+4% scheme, meaning that the company will contribute an amount equal to 4% of employee’s salary by default. On any additional contribution from the employee’s salary up to 4%, the employer will match dollar-for-dollar. Employee can contribute more than 4% of their salary to the pension plan, but the employer will not match this amount. Contributions maximizing the employer’s match in this example is 4%. Of course, this does not mean that contributing more money to the retirement savings of some kind is not recommended. It is just that you may access more suitable investment options outside of the employer-sponsored plan.
To summarize, the main difference between the defined benefit and defined contribution pension plans is who own the risk of future value of retirement savings. In the case of defined benefit plan it is the employer, who guarantees the benefit, i.e. future income. In the case of defined contribution plan, the risk is owned by the employee, while the employer guarantees contribution but is not responsible for the outcome of the investment strategy.
