Defined-Benefit vs. Defined-Contribution Plan: An Overview
Employer-sponsored retirement plans are divided into two major categories: defined-benefit plans and defined-contribution plans. As the names imply, a defined-benefit plan—also commonly known as a traditional pension plan—provides a specified payment amount in retirement. A defined-contribution plan allows employees to contribute and invest in funds and other securities over time to save for retirement.
These key differences determine which party—the employer or employee—bears the investment risks and affect the cost of administration for each plan. Both types of retirement accounts are also known as a superannuation in some countries.
Key Takeaways
- Employers fund and guarantee a specific retirement benefit amount for each participant of a defined-benefit pension plan.
- Defined-contribution plans are funded primarily by the employee, as the participant defers a portion of their gross salary; employers can match the contributions up to a certain amount, if they choose.
- A shift to defined-contribution plans has placed the burden of saving and investing for retirement on employees.
- The most popular defined-contribution plan is the 401(k).
- A steady trend has emerged of companies favoring defined-contribution plans over defined-benefit plans.
Defined-Benefit Plan
Defined-benefit plans provide eligible employees with guaranteed income for life when they retire. Employers guarantee a specific retirement benefit amount for each participant based on factors such as the employee's salary and years of service.
Employees have little control over the funds until they are received in retirement. The company takes responsibility for the investment and distribution to the retiree. That means the employer bears the risk that the returns on the investment will not cover the defined-benefit amount due to a retired employee.
Because of this risk, defined-benefit plans require complex actuarial projections and insurance for guarantees, making administration costs very high. As a result, defined-benefit plans in the private sector are rare and have been largely replaced by defined-contribution plans over the last few decades. The shift to defined-contribution plans has placed the burden of saving and investing for retirement on employees.
Defined-benefit plans are broken down into two payment options: annuity and lump-sum payments. In an annuity payment plan, the payment is spread out and paid monthly until death. A lump-sum payment is the entire value of the plan paid at one time.
Opting to take defined payments that pay out until death is the more popular choice, as you will not need to manage a large amount of money, and you're less susceptible to market volatility.
While they are rare in the private sector, defined-benefit pension plans are still somewhat common in the public sector—in particular, with government jobs.
Defined-Contribution Plan
Defined-contribution plans are funded primarily by the employee. The most common type of defined-contribution plan is a 401(k). Participants can elect to defer a portion of their gross salary via a pre-tax payroll deduction. The company may match the contribution if it chooses, up to a limit it sets.
As the employer has no obligation toward the account’s performance after the funds are deposited, these plans require little work, are low risk to the employer, and cost less to administer.
The employee is responsible for making contributions and choosing investments offered by the plan. Contributions are typically invested in select mutual funds, which contain a basket of stocks and/or other securities, and money market funds. However, the investment menu can also include annuities and individual stocks.
The investments in a defined-contribution plan grow tax-deferred until funds are withdrawn in retirement. There is a limit to how much employees can contribute each year. For example, the limit on employee contributions to a 401(k) in 2023 is $22,500. Those over 50 can contribute up to $30,000 with the $7,500 catch-up contribution. In 2024, the standard limit is $23,000, meaning those over 50 can contribute up to $30,500.
Another type of defined-contribution plan is a 403(b). While both the 403(b) and 401(k) are tax-deferred, a 403(b) is much less common as it is restricted to those in non-profit, charitable organizations, and public schools and colleges. 403(b) plans are often managed by insurance companies and offer fewer investment options when compared to a 401(k), which is often managed by a mutual fund.
Advisor Insight
ChrisChen, CFP®, CDFA®
Insight Financial Strategists LLC, Waltham, MA.
It’s all in the nomenclature. Defined-benefit plans define the benefit ahead of time: a monthly payment in retirement, based on the employee’s tenure and salary, for life. Usually, the funding expense accrues entirely to the company. Employees are not expected to contribute to the plan and do not have individual accounts. Their right is not to an account but to a stream of payments.
In defined-contribution plans, the benefit is not known, but the contribution is. It comes in a designated amount from the employee, who has a personal account within the plan and chooses investments for it. As investment results are not predictable, the ultimate benefit at retirement is undefined. Nevertheless, the employee owns the account itself and can withdraw or transfer the fund, within plan rules.
Defined-Benefit Plan vs. Defined-Contribution Plan Example
Many private-sector employees are offered and participate in a defined-contribution plan. Such plans carry less risk for the employer as they are not responsible for managing the account themselves. They also provide much more flexibility to the employee.
John's Defined-Contribution Plan
If John were to contribute to a defined-contribution plan such as the popular 401(k), he could make his own investment decisions for the money in his account (although investment choices are limited to what the plan offers).
For example, he could take an extremely aggressive approach with his investments since he is young and has time to weather a potentially volatile market. His company offers a 3% match, and he adds that money to what he invests for his retirement.
When John reaches retirement age, he starts making withdrawals from the plan. Over the course of his career, he adjusted the investments in his account to ensure that they matched his changing investment profile. As he approached retirement age, John made sure he invested less aggressively to try to maintain the stability of his account's value.
John's Defined-Benefit Plan
If John's employer offered a defined-benefit plan, his employer would fund the pension itself, perhaps with some extra contributions from John. It would then give the pension money to an outside investment firm to manage or invest the funds itself. John has no say in what the company invests in, and he has to trust that they will be able to make their payouts from the plan come retirement.
If the company makes a mistake when investing and does not have the amount to pay John when he is ready to receive it, there isn't much John can do. He has saved a lot of time not having to research investments and make decisions. However, he lacked the control over his investments that he would have had with a defined-contribution plan.
What Is the Difference Between a 401(k) Plan and a 403(b) Plan?
A 401(k) plan is a defined-contribution plan offered to employees of private sector companies and corporations. A 403(b) plan is very similar, but it is provided by public schools, colleges, universities, churches, and charities. According to the IRS, investment choices in a 403(b) plan are limited to those chosen by the employer.
Why Is a Defined-Contribution Plan More Popular With Employers?
A defined-contribution plan is more popular with employers than the traditional defined-benefit plan for a few reasons. With the former, employers are no longer responsible for managing investments on behalf of employees and ensuring that they receive specific amounts of money in retirement. The employees themselves have to manage that outcome. Defined-contribution are also less complicated and expensive to manage.
Can SEP IRAs Be Combined With a Defined-Benefit Plan?
You can combine a SEP IRA with a defined-benefit plan, depending on whether or not the SEP is a model SEP or a non-model SEP. The type of SEP is determined by the filing of IRS Form 5305, and you would need to confirm which type of SEP you have with your SEP custodian.
The Bottom Line
Defined-benefit plans and defined-contribution plans are two retirement savings options. Defined-benefit plans, or pensions, are preferred by most employees because they deliver a defined monthly amount in retirement. However, because defined-benefit (pension) plans place the burden on the employer to invest for their employees' retirement years, they are much less common today than they once were.
More ubiquitous in recent decades is the defined-contribution plan, such as a 401(k) plan. With these plans, employees are responsible for saving and investing for their retirement years. They are less expensive and easier to sponsor than defined-contribution plans and, thus, are more popular with employers. However, among employees, defined-contribution plans are less preferred than defined-benefit plans. Whereas defined-benefit plans offer a guaranteed income in retirement, defined-contribution plans place the responsibility to save on the employees—and simply put, many don't. An estimated 40% of Americans enter retirement relying on Social Security benefits for their entire income, with no additional savings.
