Defined Benefit Pension Plan Vs. Defined Contribution Plan
A company pension plan can be a valuable source of retirement income. There are two types: defined benefit and defined contribution. Both provide income after retirement, but they are different in how they work. In this article, I’ll compare the two and let you know the advantages and disadvantages of each. Let’s get started.
How Defined Benefit Pension Plans Work
A defined benefit pension plan provides an employee with a lifetime guaranteed income at retirement. The amount you will receive is based on several factors, including your average salary and length of service. With most defined benefit plans, the employer and employee contributes, but the burden of ensuring that the plan remains fully funded falls on the employer.
Defined benefit plans were once the standard pension offered by most employers, but they’ve become increasingly rare because of how costly they are for employers. Most companies have shifted towards less expensive defined contribution plans, with governments and a small number of corporations being among the last defined benefit holdouts.
Defined Benefit: Sample Formula
The method used to determine income under a defined benefit plan varies, but here is an example of a standard formula:
Monthly Pension Based on Final Earnings
The following formula determines the employee’s monthly retirement income by multiplying a percentage of average earnings by the total years of service:
Monthly pension = 2.0% X avg. monthly earnings of the last five years X years of service
For example, an employee earned an average of $80,000 per year during their last five years. If their total years of service was 25 years and they were a member of the pension for that entire time, the employee would receive the following annual pension benefit at retirement:
$80,000 X 2% X 25 = $40,000/year.
This calculation assumes that the employee leaves at their regular retirement date and isn’t subject to any benefit reduction.
Advantages of Defined Benefit Pensions
Defined benefit pensions offer several advantages for employees, and if you’re lucky enough to have a defined benefit plan, you must think long and hard about ever giving it up. Here are some of the key benefits:
Provides a Guaranteed Income for Life
Unlike defined contribution plans, most defined benefit pension plans guarantee a predetermined income for life. This guarantee provides peace of mind knowing that you can count on a specific income amount over and above other sources, like CPP or OAS.
It Makes Retirement Planning Easier
Defined benefit plans make retirement planning easier because you know how much income you will receive. If your pension income isn’t enough to support your desired retirement lifestyle, you can make plans well in advance to cover shortfalls.
Employer Shoulders the Risk
With defined benefit plans, employees can have peace of mind because employers guarantee funds will be available to cover their retirement income. Employers audit their defined benefit plans regularly, and the deficits must be funded solely by the employer if there’s a shortfall of funds.
It Includes Survivor Benefits
If you pass away before your spouse, your defined benefit pension will continue to provide income to your beneficiary for the remainder of their lifetime. The pension company will likely reduce the benefit amount to 50% or 60% of the original figure. However, they may allow your survivor to maintain 100% of your pension income if you opt for a lower payment when you retire.
Disadvantages of Defined Benefit Pensions
Defined benefit plans are desirable, but they aren’t perfect. In an age when employees change jobs several times throughout a career, fewer and fewer people make the most of their defined benefit plans, which would require remaining with the same employer for decades. Here are a few other drawbacks.
They Are Very Costly to Maintain
Because the employer must guarantee a lifetime income, defined benefit pensions are far more costly to maintain than defined contribution plans. As a result, more and more employers are opting out of defined benefits pensions, choosing to go the less costly defined contribution route. That’s a disadvantage to employees who miss out on the peace of mind that comes with a guaranteed income.
Employee Has No Control Over How Funds Are Invested
The employee doesn’t make any investment decisions with a defined benefit plan. While this may be a relief to some, others prefer to have a say in managing their hard-earned retirement nest egg.
There Is Pressure to Work Longer
Many employees feel pressured to stay with the same employer or work longer than they want to receive their maximum pension income at retirement. It’s why defined benefit plans are often called golden handcuffs.
While defined benefit plans allow you to adjust your retirement date, they will reduce your benefit if you go early. As a result, you may stay at your job longer than you had hoped.
Difficult to Understand
Defined benefit plans can be confusing and involve complex actuarial projections. It can be challenging for employees to know the actual value of their pension and make sense of their retirement options.
Employer Could Mismanage the Fund
While unlikely, your entire pension could be compromised if an employer mismanages the pension funds. What happens if your employer goes bankrupt? There are no guarantees that your pension wouldn’t be cut.
How Defined Contribution Pension Plans Work
The contribution is defined with a defined contribution plan instead of the eventual benefit. The employee is responsible for making contributions and a match from the employer. Employees can usually choose how much they wish to contribute and their investment by selecting from fund portfolios representing the various asset mixes, i.e., Conservative, Income, Balanced, and Growth.
More than ever, companies are choosing defined contribution plans over defined benefit plans because they are cheaper for the employer and far easier to administer. The employer is not required to provide a specific monthly benefit after retirement.
Advantages of Defined Contribution Pensions
The advantages of defined contribution plans for the employer are pretty clear. But while most employees would prefer to have a defined benefit plan, they can also gain from being enrolled in a defined contribution plan.
More Control Over Your Investments
You choose how your money is invested. That’s not the case with a defined benefit plan, where all pension funds are pooled together and invested similarly.
Flexible Withdrawal Options
Depending on your employer plan, you may have more options when withdrawing defined contribution funds, either at retirement or leaving the company early.
Disadvantages of Defined Contribution Pensions
While defined contribution plans offer flexibility, they have their drawbacks. Here are some risks you’ll face with this type of plan.
Your Retirement Income is Not Guaranteed
The primary drawback of a defined contribution vs. direct benefit is that your retirement income is not guaranteed. How much money you can draw in retirement will depend on how much you contributed and how your investments performed during your working years. While no one should rely solely on their pension income, this is especially true with a defined contribution plan.
Limited Investment Choices
While you decide how to invest your defined contribution funds, your options will likely be limited to a selection of mutual fund portfolios. Chances are, you won’t be able to purchase lower-cost ETFs, and individual stocks will certainly not be an option.
The Risk Falls on the Employee
Because employers are not responsible for your retirement income, the risk falls to the employee. To minimize that risk, you must remain consistent with your investment contributions and look to build other income sources to draw on once you retire.
Defined Benefit vs. Defined Contribution: Which Is Better?
While defined benefit plans place most of the risk with the employer, defined contribution pensions are now the norm and offer flexibility, especially if you decide to change jobs. The key to having success with a defined contribution plan is making sure you enroll and maximizing your allowable contributions.
And remember, regardless of the type of pension you have, don’t make it your only source of retirement income. You’ll get CPP and OAS, but that might not be enough. Contribute what you can to other registered products, like RRSPs and TFSAs.
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