Company pensions are often categorized as defined benefit (DB) or defined contribution (DC). A defined benefit plan states the specific benefit that a retiree will get. The calculation accounts for certain factors like how many years an employee has worked and the salary received, which dictates the pension one will get. A defined contribution plan relies on how much employees contribute to their pension pot. Ideally, although not all the time, an employer may also contribute to these plans. How is defined benefit different than defined contribution? Here are the major differences between these two.
How the Benefit Is Determined
The amount in a defined contribution plan is simply your account’s value when you withdraw the funds. Several factors contribute to the plan’s formula in a defined benefit plan. A plan’s formula has three factors, which are :
- A multiplier
- The years one has served a company
- The average of an individual’s highest annual salary over a specific period
Individual Accounts
A DC plan has individual accounts holding the employer’s contribution, employee deferrals, and investment gains or losses on the contribution. DB plans do not have individual accounts.
Who Contributes
Most DC plans permit employee deferrals and employer contributions. On the other hand, most DB plans neither allow nor require employee contributions. An individual’s benefit is often fully funded by a company.
Time of Distribution
Even after age 59 and a half, most DC plans will still permit in-service distributions, hardship withdrawal, or even both. Although DB plans can allow in-service payments, most hardly do.
Amount Contributed
A certain set of formulas determines the contribution amount required by a DC plan sponsor. For instance, the matching contribution formula. In a DB plan, the contribution amount needed by a DB plan sponsor is based on several factors to make sure that the benefit plan is well funded.
Investment Risk
What’s the difference between DB and DC? Mostly, in DC plans, participants can often choose how their accounts will be invested from the various options that the employer will select for them. In a DB plan, it is the responsibility of the company to invest.
Vesting
Employee deferral contributions are 100% immediately vested in a DC plan. However, employer contributions can, at times, be subjected to a vesting schedule. The schedule can either be graded vesting (this is where, after two years of service, the contributions are 20% vested, after three years, 40% vested, and so on). The other vesting schedule is cliff vesting. This is where the contributions are not vested in bits but rather 100% vesting immediately after three years of service. On the other hand, DB plans mostly use a five-year cliff vesting schedule.
Benefits Guaranteed
The Pension Benefit Guaranty Corporation (PBGC) guarantees DB benefits up to a certain level in case one’s plan is terminated without adequate assets to pay all the benefits. In a DC plan, there is no such guarantee.
Now that you know the difference between DB and DC, you are better positioned to choose a benefits plan that works for your employees.
At Fiduciary Advisors, LTD., we can help you design an employee retirement program that is good for you. We are familiar with the different company pension plans and can help you choose the right one. Give us a call today for more information.