If you are receiving a pension, whether it be public or private along with Social Security, you are the beneficiary of a defined benefit. On the other hand, if you are receiving a monthly payout from a retirement plan that you (and perhaps your employer) contributed towards think: 401(k), 403(b), 457, etc.., you are drawing from a defined contribution plan.
If you planned for retirement using both the defined benefit AND defined contribution approaches, you have undoubtedly planned wisely! Both retirement plans have their advantages, which counterbalance their disadvantages.
Let’s explore both options.
Defined Benefit Plan Advantages
Pension plans, both public and private, are defined benefits. Their monthly payouts are based on years of service, highest salary(s) received among other factors. What all defined benefit packages have in common is the longevity requirement and the fact that the employer contributes everything. The only requirement to be eligible to receive this pension is you must stay with the employer for a predetermined amount of time.
Also, you don’t have to look after the solvency of the pension plan. You don’t have to track how the pension account is invested or worry about payouts. It’s all part of a compensation package that is another incentive to remain loyal to your employer for the long haul.
We mentioned Social Security as a defined benefit. Technically, it is, even though you fork over 6.2 percent of your salary, and your employer kicks in the same. There is no timetable that it expires on no dollar amount tied to your benefit. It is based on your earnings along with when you decide to start receiving your monthly check.
Defined Benefit Plan Disadvantages
The main disadvantage of a defined benefit plan is that your employer will often require a minimum amount of service and if you don't make it passed that threshold, you will most likely get nothing. Although private employer pension plans are backed by the Pension Benefit Guaranty Corp up to a certain amount, government pension plans don’t have the same protection.
The other issue is that defined benefit packages can succumb to the pressures of costs and the volatility of investment markets. Defined benefit plan payouts also seem to be less popular than a private-sector tool for attracting and retaining employees.1
Defined Contribution Plan Advantages
Deferred contribution plans rely on you making contributions every year and can include employer matching contributions. The most common defined contribution plans are Traditional IRAs, Roth IRAs, and 401(k) plans. With good planning, the employee can set aside retirement savings, which they own immediately vs the time requirement for defined contributions and are transportable from one job to another. Any growth compounds over time and grows tax deferred.
One advantage is that you have more control and flexibility over how you invest as well as how much you contribute to the plan. Then there are the tax benefits: immediate deductions or deferred tax advantages, which can accrue with before-tax earnings (Traditional IRAs, for example) and after-tax contributions (for Roth IRAs). If you contribute to a pre-tax account, you will be taxed when you withdraw the money during your retirement years. There is a potential for that tax rate to be lower as most of us have been told will be the case over many years now but there is also the very real possibility that tax rates will be higher in the future.
Defined Contribution Plan Disadvantages
The downside of defined contribution plans is that they require discipline and management - no investment should ever be "set it and forget it." Life as we know it has a funny way of constantly changing course and realigning our priorities - sometimes away from the future and retirement planning. Additionally, most people don’t have the expertise to invest properly or the process to create consistent results.
As with everything in life, there are pros and cons. The incentive in a defined benefit plan is for you the employee, to remain with the same employer, who assumes the risk and expenses. However, there are no guarantees in life and that the plan may not exist or offer the originally promised benefits in the future. Whereas defined contribution plans give you full control but with that control comes greater risk. Poor savings habits and bad investments could result in zero retirement savings.
Naturally, each type of retirement plan has its place in your retirement plan. When it comes to deciding which basket to use to park your nest eggs, your best bet is to diversify, get sound financial advice from someone who has helped hundreds of families through this and keep adapting with the times to stay on track for a comfortable retirement.