Defined contribution (DC) pensions and defined benefit (DB) pensions are two major types of retirement plans. DC pensions have become more popular in recent years. In a DC pension, employees and employers contribute fixed amounts into the employee’s individual account. The retirement benefit depends on the investment returns of the account. In contrast, in a DB pension, employers promise employees a specific monthly benefit at retirement. The employer is responsible for funding the promised benefits and takes on the investment risks. There are key differences between DC and DB pensions in aspects like investment risk, benefit amount, portability, and cost structure. Understanding these differences can help employees choose suitable retirement plans and better manage their retirement finances.
DC pensions have higher investment risks for individuals while DB pensions have risks for employers
A key difference between DC and DB pensions lies in who bears the investment risks. In a DC pension like 401(k), the employee bears the risks of investment losses or poor returns. The retirement benefit depends on how the market performs and how successfully the funds are invested. In contrast, in a DB pension, the employer bears the funding risks and is responsible for ensuring enough money is set aside to pay the promised benefits. However, DB pensions face risks like underfunding if assumptions about market returns or lifespans are wrong.
DC pension benefits depend on account balances while DB pensions guarantee set monthly incomes
In a DC pension, the retirement benefit depends on the employee’s account balance at retirement. Higher contributions and better investment returns lead to larger benefits. But the monthly income isn’t guaranteed. In a DB plan, the benefit is determined by a formula based on salary history and years of service. Retirees get fixed monthly payments for life regardless of investment performance or account balance. But the guaranteed income may be lower than potential DC pension amounts in bull markets.
DC pensions are portable while DB pensions depend on employer and plan rules
DC accounts like 401(k)s are fully portable when changing jobs. The employee owns the account and can roll it over into a new employer’s plan or an IRA. DB pensions are tied to the employer. Changing jobs before the vesting period may lead to forfeiting benefits. Retirees may get lower monthly payments if taking the pension as a lump sum when leaving the job early. Portability makes DC plans suited for more mobile workforces.
DC pensions have predictable costs while DB plan costs fluctuate
In DC plans, employers and employees contribute known amounts consistently, making costs predictable. In DB pensions, employers must make up for funding shortfalls to pay promised benefits. Market downturns, longer lifespans increasing payouts, and other factors can all raise required contributions. The fluctuating and often rising costs have made many employers freeze or terminate DB pensions in favor of DC plans.
DC pensions are better suited for a mobile workforce while DB plans provide guaranteed retirement incomes. But both have risks that employees should understand. Combining both plans can balance these risks and maximize retirement security. Employees should also contribute sufficiently and invest appropriately for their DC pensions.