What is the difference between a defined benefit and defined contribution pension?
This past weekend I took a mini-holiday and visited Toronto. On Saturday night, I went out with some friends for dinner and the topic of personal finance came up – which as you know is one of my favorite topics! My friend, Caroline, who has been in the Consumer Packaged Goods (CPG) industry for years, was telling us that she has a pension. My first thought was wow, I’ve been in tech for a number of years and have built my own retirement plan; this is because the companies that I have worked for did not have employee pension plans.
Let’s breakdown the differences between the 2 types of pensions
There are two types of retirement plans:
1- Defined Benefit
2- Defined Contribution
A defined benefit pension plan is a retirement account where your employer invests money on your behalf which can provide a specified payment amount in retirement. This means that you be able to collect a specified amount of money once you retire.
With a defined contribution plan, this allows you and your employer to invest money over time to save for retirement.
Defined Contribution Plans
Defined contribution plans are funded primarily by the employee, and the employer can deliver matched contributions up to a certain amount.
The most common type of defined contribution plan, which many people are familiar with, is a 401(k) plan in the US, and an RRSP in Canada. The employee may elect to defer a portion of their gross salary via a pre-tax payroll deduction to the plan, and the company matches according to plan.
The contributions can be invested, at the employee’s direction, in a variety of investments vehicles such as mutual funds, money market funds, annuities, or stocks.
This is more of a employee managed fund as the employer no longer has any obligation on the account's performance after the funds are deposited, these plans require little work and are low risk to the employer. The employee must direct contributions and investments to grow the account in order to provide in retirement.
Defined Benefit Plans
When it comes to a defined benefit plan, this is where employers guarantee a specific amount that the employee will receive in retirement.
The amount can be based on the employee's salary, years of service at the company, etc. In this scenario, the employee has little control over the funds until they are received in retirement and the employer is the one that holds the investment risk, therefore they need to ensure that the defined benefit amount is able to be paid to the retired employee.
The Bottom line
Because defined benefit plans are more costly for employers than defined contribution plans, in recent years several companies have scaled back these plans dramatically or eliminated these plans altogether. If you still have a defined benefit plan at your company, consider yourself lucky.
Summary
There are two types of employer-sponsored retirement plans: Defined benefit pension plans and defined contribution plans.
Defined contribution plans are funded primarily by the employee, where the employee defers a portion of their gross salary (until retirement) and the company (employer) matches the contribution.
Employers guarantee a specific retirement benefit amount for each participant of a defined benefit plan