Defined Contribution versus Defined Benefit

Posted by Mike Smith :: August 31, 2007 @ 6:22 am

It’s never too early to start thinking about retirement. When you’re making your plan, it’s important to understand the difference between a defined contribution plan and a defined benefit plan.

The Defined Benefit Plan:
The defined benefit plan that people are the most familiar with is a pension plan. The way it works is that you get credit for the number years that you contribute to the plan. Contributions are generally small and based on a percentage of your salary. Your company, or an outside firm that they hire, will invest the contributions to ensure that they will be able to cover the benefits that need to be paid out down the road.

When you retire, the amount that you receive will generally be based on your current salary and the number of credits that you have. The actual formulas can get quite complicated, but years of service and final pay tend to be the most heavily weighted components. This type of plan is called a defined benefit plan because the amount of the payout is based on a predetermined formula. If two people both participated in the plan for the same amount of time and had the same final salary, then the benefit that they would be entitled to would generally be the same.

The Defined Contribution Plan:
The most common example of a defined benefit plan is a 401K. In this case, you contribute a set percentage of your paycheck into a tax-deferred account each pay period. You then select from a variety of investment options to determine how your money will be invested. When you retire, the amount that you receive will be based on the value of the accumulated assets in your account. This type of plan is called a defined contribution plan because the amount that you put in is known, but the amount that comes out is not.

Why You Should Care:
Many companies today are transitioning away from defined benefits plans. As the number of workers contributing to defined benefits plans decreases relative to the number of former employees receiving benefits, the cost of the plans becomes more and more expensive for employers. What’s more, the company must carry the liability of ensuring that a defined benefits plan will meet its performance requirements.

More and more workers are starting to find that a defined contribution plan is their only company sponsored retirement plan option. Unlike a defined benefits plan, where you would just need to make your contributions to receive your benefits upon retirement, defined contribution plans require continual action on your part to grow as efficiently as possible. If you make poor investment choices, or allow your account to under-perform, it will be your standard of living in retirement that will suffer.

Regardless of which plan you have in place, we here at Lending Club always recommend a diversified approach to saving money. Put some portion of your savings into different types of accounts to help ensure a good outcome for yourself.