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Understanding Defined Contribution and Defined Benefit Pension Systems – Which One is Right for You?

Jeffrey R. Davis

The Basics of Common Pensions Plans – What you Should Know to Protect Yourself and Your Retirement

You may have heard about it on the news or had your employer speak to you about it when starting your job. Everyone who is covered under a pension system and, to some extent, even those who are not should have a solid understanding of the mechanics of a pension fund. Pension funds make for great investment vehicles and can help you protect your retirement investment. Knowing what they are, how they’re used, and what to avoid should help build confidence in your retirement wealth.

What is a Pension Fund?

A pension fund is a fund that is established and utilized by an employer (or a government in the case of state employees) to facilitate and organize the investment of employees’ retirement funds. A Pension fund is a collection of assets and securities such as stocks, bonds, real estate, options contracts, money market funds, etc. which earn a specific rate of return. These assets are typically “safe,” in the sense that pension managers invest in securities that have low risk and reduce risk further by investing in a wide variety of investments. The total, aggregate return of the pension fund pays for retired employee benefits.

Type of Pension Funds

There are two types of pension funds: the defined contribution fund and the defined benefit fund.

Defined Contribution

In a nutshell: in a defined contribution plan, you pick among selected investment types and you and your employer contribute to the investments you pick.

A defined contribution fund is a pension fund that is established by the firm for its employees. Both the employer and the employee make contributions to the fund but the employee bears responsibility for the fund’s performance. With a defined contribution plan, the firm’s major obligation is to make the promised contributions (which vary depending on the employer’s contribution system) to an employee’s retirement account. In return, the employee is responsible for the management and investment of those contributions, usually by selecting among various investment and securities categories the employers has agreed to contribute to.

Since the fund is meant for retirement, restrictions exist to limit withdrawal before retirement age. Earnings acquired in this type of retirement plan typically are not taxed until they are withdrawn. But pension funds do employ restrictions such as penalties in all but a few special circumstances in order to limit withdrawals before retirement.

Unfortunately, employees who are retiring experience difficulty when determining how much a pension fund will ultimately provide, since the employer must only make promised contributions outlined by the employer’s plan. Defined contribution plans come with no guarantee on the final amounts available for retirement. In other words, the contributions are known, but the benefit is unknown. Because of this, employees must take extra precautions to ensure that the pension receives sufficient contributions to meet retirement goals.

Defined Benefit

In a nutshell: the employer provides for retirement benefits based on employee factors such as employment and salary history. The employer is ultimately responsible for the benefits.

A defined benefit fund is an employer-sponsored retirement plan where employee benefits are calculated based on a formula that incorporates variables such as salary history and duration of employment. Unlike a defined contribution plan, the company is responsible for fund performance. In a defined benefit plan, the employer has an obligation to provide a specified annual retirement benefit.

Under a defined benefit system, employees typically face the same restrictions and penalties as defined contribution plans when it comes to withdrawing funds. If the fund’s total investment returns do not earn enough to make pension obligation payments, the remaining obligations become liabilities for the company offering the defined benefit plan.

The main benefit of the benefit plan (no pun intended) is that payouts made to retiring employees are guaranteed to provide you with retirement income for life.

Main Difference Between Defined Contribution and Defined Benefit

As you can see the main difference between a defined benefit plan and a defined contribution plan is mainly on who has control and management of the pension fund. In a defined contribution plan, the employee manages the fund and the employee bears the risks of investment nonperformance and retirement benefit losses. In a defined benefit plan, the employer controls and manages the pension fund and assumes responsibility for employees’ retirement benefits. Because of this, the employer bears the risk that inappropriate, poor, or unfortunate investments will leave the fund with insufficient return to pay beneficiaries. If the investment returns prove insufficient, the employer is on the hook for the gap.

Example of a Defined Contribution Plan – Johnny Employee and Company DC

Let’s use an example to clarify the differences. In a defined contribution plan, Johnny Employee selects an independent fund (one not associated with the employer) such as Vanguard, Fidelity, or ING. After this selection is made, Company DC (defined contribution) is only responsible for contributing the portion of money that was promised to Johnny Employee pursuant to their employment contract. Contribution could be based, for example, on whether Company DC earned any profits in that year. Thus, if the Employer suffered a loss during the year, there would be no contribution made to the plan. Stock performance is another example of contribution conditions. If Company DC’s stock performs well, contributions could flow to employees’ independent funds. There is a flip side; if Company DC’s stock tanks, contributions could slow to a trickle or cease to come at all.

It’s clear that defined contribution plans come with considerably larger risks to the employee then defined benefit plans. But it’s not just risk you have to worry about – our friend Johnny Employee will have a difficult time calculating the total amount of benefits he will receive in the future since he cannot reliably determine the total contributions to the pension fund. Not good if you are like most people and have goals for retirement that you need to hit.

So Much Risk! What’s the Catch?!

Don’t let the higher risk fool you. There’s one crucial plus unique to these plans. Defined contribution plans are classic examples of the tradeoffs of risk vs. return. How so? Defined contribution plans enable employees to retire richer than they planned for – much richer in the case of savvy (and lucky) investors who can deploy their pension assets to generate serious return.

Example of a Defined Benefit Plan – Johnny Employee and Company DB

Now let’s look at a defined benefit plan. Company DB sets up a pension fund and chooses the investments that the fund will invest in. The company will use an actuary to make an assumption about the rate of return that will be earned on the plan’s assets. Company A will then use the assumed rate of return to compute the amount that the firm must contribute regularly. Assuming the rate of return is accurate and assuming the company makes those regular contributions, employees retire with set benefits. Simple, right?

For instance, an employer may promise to pay a retired employee a yearly amount equal to 3% of the employee’s final annual salary for each year of service. A 20-year employee would then receive an annual benefit of 60% (3% X 20 years = 60%) of their final salary. Thus, if an employee was making $100,000 as their final salary, the benefit that was promised would be $60,000 as demonstrated below:

( Final Salary [$100,000] X Annual Benefit Percentage [60%] = Annual Benefit [$60,000])

Company DB’s Obligation

The payments that companies need to make to retired employees are considered to be the pension liabilities. An employer is obligated to make this payment to the employee. Of course, the company should have no problem making benefit payments assuming the fund’s investments generate the estimated rate of return. So, in order to pay Johnny Employee his $60,000 benefit, a pension fund with $1,000,000 in invested securities must earn a 6% rate of return. If the fund only attains 5% (which would be $50,000) the employer would have to make up the difference of $10,000 by paying it directly from company assets, earnings, or profits. Not good for the company, no sweat for our old and retired friend Johnny.

Key Points

Primarily, defined contribution and defined benefit plans make up the two types of pension funds that employees and employers may use to plan for employee retirement. Risk tolerance, investing experience, and retirement goals can help you determine which type of pension fund is the most appropriate for you. Specifically, the defined benefit plans provide the best alternative to employees interested in predictable and dependable retirement benefits since it shifts risk to the company and promises stable retirement income. Those with greater risk tolerance and savvy investment knowledge may forego dependability in the name of a dream retirement fund. To each his own.

Next week we’ll go into more detail about defined benefit plans and what to avoid. Stay tuned. Be sure to comment below to let us know what you thought about this week’s topic.

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