How Defined Benefit Plans Differ from Defined Contribution Plans

According to Franco Modigliani and Frank J. Jabozzi in their book ‘Capital Markets, Institutions and Instruments’, the two basic and widely used types of pension plans are defined benefit plans and defined contribution plans.

In a defined benefit plan, the plan sponsor (the entity that establishes a pension plan) agrees to make specified payments annually to qualifying employees beginning at retirement and some payments to beneficiaries in case of death before retirement. These payments typically occur monthly. The retirement payments are determined by a formula that usually takes into account the length of service of the employee and the employee’s earnings. The pension obligations are effectively a debt obligation of the plan sponsor. The plan sponsor, thus, assumes the risk of having insufficient funds in the plan to satisfy regular contractual payments that must be made to retired employees.

A plan sponsor establishing a defined benefit plan can use the payments made into the fund to purchase an annuity policy from a life insurance company. Defined benefit plans that are guaranteed by life insurance products are called insured plans. However, it is important to note that an insured plan is not necessarily safer than a non-insured plan because it depends on the ability of the life insurance company to make the contractual payments, whereas the uninsured plan depends on the ability of the plan sponsor.

Benefits become vested when the employees reach a certain age and complete enough years of service so that they meet minimum requirements for receiving benefits upon retirement. The payment of benefits is not contingent upon a participant’s continuation with the employer or the union.

In a defined contribution plan, the plan sponsor is responsible only for making specified contributions into the plan on behalf of qualifying participants, not specified payments to the employee after retirement. The amount contributed is typically either a percentage of the employee’s salary and/ or a percentage of the employer’s profits. The plan sponsor does not guarantee any specific amount at retirement. The payments that will be made to qualifying participants upon retirement depends upon the growth of the plan assets. That is, retirement benefit payments are determined by the investment performance of the funds in which the assets are invested and are not guaranteed by the plan sponsor. The plan sponsor gives the participants various options as to the investment vehicles in which they may invest.

To the firm, this kind of plan offers the lowest costs and the least administrative problems. The employer makes specified contributions to a specified plan/ program, and the employee chooses how it is invested. To the employee, the plan is attractive because it offers some control over how the pension money is to be managed.

The defined contribution plans come in several legal forms: 401(k) plan, 403(b) plan, or the 457 plan; which will not be discussed now in this article.

In summary, the fundamental differences that separate these two types of pension plans can be stated as follows: In the defined benefit plan, the plan sponsor guarantees the retirement benefits, makes investment choices, and bears the investment risk if the investment does not earn enough to fund the guaranteed retirement benefits. On the other hand, in a defined contribution plan, the employer does not guarantee any retirement benefits, but the employer does agree to make specified contributions to the employee’s account; the employee selects the investment options; and the employee’s payments come from the returns on the investment portfolio plus, of course, the employee’s and employer’s contributions.