Defined Benefit and Contribution Pension Plans

_{From Harmon W. McKinney, Jr. | "Your Guide to Retirement Planning"}

Differences along with advantages and disadvantages of both

A defined contribution plan provides an individual account for each participant. The benefits are based on the amount contributed and are also affected by income, expenses, gains and loses. The annual contributions in a defined contribution plan cannot exceed the smaller of $40,000 or 100% of the participant’s compensation. An employer’s deduction benefit may not exceed 25% of eligible compensation. Some examples of defined contribution plans include 401(K) plans, 403(b) plans, employee stock ownership plans and profit sharing plans.

A defined benefit plan promises the participant a specific monthly benefit at retirement and may state this as an exact dollar amount. Monthly benefits could also be calculated through a formula that considers a participant’s salary and service. A participant is generally not required to make contributions in a private sector fund but most public sector funds require employee contributions. Unlike defined contribution plans, the participant is not required to make investment decisions.

Advantages of Defined Benefit Plans

Guaranteed retirement income security for workers
No investment risk to participants
Cost of living adjustments
Not dependant on the participant’s ability to save
Tax deferred retirement savings medium

Disadvantages of Defined Benefit Plans

Difficult to understand by participant
Not beneficial to employees who leave before retirement

Advantages of Defined Contribution Plans

Tax deferred retirement savings medium
Participants have a certain degree of how much they choose to save
Can be funded through payroll deductions
Lump sum distributions may be eligible for special 10 year averaging
Participants can benefit from good investment results
Easily understood by participants

Disadvantages of Defined Contribution Plans

Difficult to build a fund for those who enter late in life
Participants bear investment risk
Annual employee salary reductions is limited to $11,000