What are the differences between defined contribution and defined benefit retirement plans?

Defined contribution (DC) and defined benefit (DB) retirement plans are two common types of employer-sponsored retirement plans, each with distinct characteristics. Here are the key differences between these two types of retirement plans:

1. Contribution Structure:

• Defined Contribution (DC):

  • In a DC plan, the contributions are typically made by both the employee and the employer, although the employee's contributions may be optional. These contributions are defined as a fixed percentage of the employee's salary or a specific dollar amount.

• Defined Benefit (DB):

  • In a DB plan, the employer is responsible for making contributions based on a formula that calculates the future retirement benefits for each employee. Employees do not typically contribute to DB plans.

2. Retirement Benefit Calculation:

• Defined Contribution (DC):

  • The retirement benefit in a DC plan is not predetermined but depends on the performance of the investments within the account. Employees build their retirement savings over time, and the final balance at retirement is the sum of contributions and investment returns.

• Defined Benefit (DB):

  • The retirement benefit in a DB plan is predetermined and based on a formula, which typically considers factors like years of service, salary history, and a benefit multiplier. Employees are promised a specific monthly or annual retirement benefit upon reaching the plan's retirement age.

3. Investment Responsibility:

• Defined Contribution (DC):

  • In a DC plan, employees have control over their investment decisions within the plan. They choose how to invest their contributions among the available investment options (e.g., mutual funds, stocks, bonds).

• Defined Benefit (DB):

  • In a DB plan, investment decisions are made by the plan sponsor (employer) and the plan's investment managers. Employees do not have control over the plan's investments.

4. Retirement Income Certainty:

• Defined Contribution (DC):

  • DC plans do not guarantee a specific retirement income. The retirement income depends on the account balance and investment performance at the time of retirement. There is no longevity risk for employers because the benefit is not guaranteed.

• Defined Benefit (DB):

  • DB plans provide a guaranteed retirement income, often for life, based on the predetermined formula. Employers bear the risk of ensuring that there are sufficient funds to meet these guaranteed benefits, which can be a significant financial obligation.

5. Portability:

• Defined Contribution (DC):

  • DC plans are generally more portable because employees can take their account balances with them when changing jobs. They have control over their retirement savings, making it easier to consolidate or manage accounts.

• Defined Benefit (DB):

  • DB plans are less portable, and the benefits are typically tied to a specific employer. When employees change jobs, they may lose access to their accrued DB benefits or have limited options for transferring those benefits.

6. Risk and Responsibility:

• Defined Contribution (DC):

  • The investment risk in DC plans falls on the employees. The retirement benefit depends on factors like investment choices, market performance, and contribution levels. Employees have more flexibility but also bear the investment risk.

• Defined Benefit (DB):

  • In DB plans, the investment and longevity risks are primarily borne by the employer or the plan sponsor. Employers are responsible for ensuring that the plan's investments generate sufficient returns to meet the promised benefits, even if investment returns fall short.

7. Popularity:

• Defined Contribution (DC):

  • DC plans, such as 401(k)s and 403(b)s, are more prevalent today, especially in the private sector. They have become the dominant retirement plan structure in many industries.

• Defined Benefit (DB):

  • DB plans are less common than they used to be and are often associated with public-sector employers, large corporations, and specific industries like education and healthcare.

8. Administrative Complexity:

• Defined Contribution (DC):

  • DC plans tend to be less administratively complex because they rely on individual account balances. Recordkeeping is generally more straightforward.

• Defined Benefit (DB):

  • DB plans involve complex actuarial calculations, investment management, and ongoing oversight, making them more administratively challenging for employers.

It's important to note that some employers offer hybrid retirement plans that combine elements of both DC and DB plans, aiming to provide some guarantees while offering investment flexibility. Employees should carefully consider the retirement benefits offered by their employers and evaluate how they align with their long-term financial goals and preferences.