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Retirement Planning: Defined Benefit vs. Defined Contribution Defined Contribution and Defined Benefit plans are the two major types of retirement pensions, which are sponsored by the United States employers. When the employee faces the need to make a choice, it becomes crucial to understand the differences between Defined Benefit and Defined Contribution plans, as both of them have their strengths and weaknesses. Defined Benefit plan is also referred to as fixed pension or traditional pension plan.
In contrast to Defined Contribution plan, this is a plan, under which the employee in the organization is eligible for getting a set monthly amount upon his or her retirement. This amount is guaranteed for the employee's life or the lives of the employee and his/ her spouse (Wiatrowski). In addition to this, if agreed, the benefit can also include a cost-of-living increase each year during the employees retirement. Also, the amount, which employee received on a monthly basis after his or her retirement usually depends on the employees length of service and wages (Zelinsky).
In its turn, Defined Contribution Plan is a special retirement savings program under which the employer agrees to make specific contributions to the employees account during his service. However, in contrast to the Defined Benefit plan, Defined Contribution Plan foresees no guaranteed retirement benefit (Turner, Muller and Verma). Under Defined Contribution Plan, the benefit received by the employee depends on the investment earnings of the plan and contributions made to it. Therefore, the benefit may cease when the employee's account balance is depleted, irrespectively of the employee's age or any other conditions the employee may face. 401 (k), 403 (b) and 457 are the most common examples of Defined Contribution Plans.
While making the choice it should be taken into consideration that historically in the United States, wages for education and government employees have been not so high like for the individuals employed in the private industry. However, the retirement benefits for those working for the private industry have traditionally been lower than for government and education employees. Yet, it should be noted that if the employer will choose Defined Contribution Plan for the employees, he will be forced to increase wages to become more competitive. To make it clearer, let's examine Defined Contribution and Defined Benefit plans more thoroughly. As it was already mentioned, Defined Contribution plan needs that an individual account should be set up for each employee.
Under this plan, the participant can contribute a fixed amount, which is based on a percentage defined by this plan, instead of being based on the employee's expected retirement benefit. There are few major types of Defined Contribution plans. For example, a profit-sharing plan, or a plan that foresees sharing profits of the business with individuals working in the company. In it turn, the amount of contributions depends on the profits of the company. Therefore, it is not a fixed amount and can differ in percentage from year to year.
Profit-sharing plans are relatively flexible, because the participant can define a maximum percentage to be contributed on a yearly basis. In such a way, the participant can contribute any amount ranging from 0 % to the percentage he or she decides to contribute. For example, the participant may decide to contribute 12 % to the profit-sharing plan and u p to 14 - 15 % to the employee's plan (Cavooris). A Stock Bonus plan is another type of Defined Contribution plan. It has much in common with the previously discussed Profit-sharing plan, with the only exception that the payments are not in the form of company's profits but in the form of the businesses's tock. Finally, it is also possible to choose what is referred to as a hybrid or paired plan.
In other words, the retirement plan may comprise of the elements of s Stock bonus plan and a profit-sharing plan. What concerns defined benefit plan, as it was also already noted, it is a retirement plan, under which it is agreed to pay a defined amount on an annual basis to the employees during their retirement period (Asthana and Lipka). Under Defined benefit plan, the amount of annual or quarterly contribution depends on the participants actuarial determination of what the benefits should be, instead of being based on profits. In such a way, calculation formulas for this type of retirement plan are focused on how much money should be contributed now to accumulate enough amount for fixed payments to the recipient in the future. Now, what concerns advantages and disadvantages of Defined benefit and Defined contribution plans, if you are within twenty years of retirement, it is better to choose Defined Benefit plan, as, in contrast to the Defined Contribution plans, this type of retirement plans foresees larger contributions on an annual basis (Wilcox).
Also, defined benefit plans are often recommended for small business owners, as they allow accumulating significantly more benefits in a shorter period of time, while the Defined Contribution plans are less flexible. In such a way, Defined Benefit plans can also be recommended for small business owners aged fifty and more who wish to write off contribution from their taxable incomes and place maximum amount possible into a tax-deferred system. Defined benefit plan is more attractive for older employees, while defined contribution plan attracts younger employees. What concerns job tenure pattern encouraged, while speaking about defined contribution plan, although the workers in the organization get benefits based on their wages (not tenure), defined contribution plan may encourage workers to change their current jobs to get access to the lump-sum distribution from their retirement accounts. In its turn, defined benefit plans foresee longer tenure that can be explained by the fact that workers get maximum benefits at the end of long-time service (Wagenbrenner). However, one of the disadvantages of defined benefit plan is that adhering to this type of retirement plan, it may get employees stuck to their current jobs they would in other case leave.
What concerns the impact of these plans on retirement patterns, defined benefit plan can be conductive to earlier retirement, and sometimes can financially penalize employees if they have worked additional years beyond the generally accepted Normal Retirement Age. In addition, due to these circumstances, defined benefit plan may force those employees to leave their jobs who would not otherwise want to retire. In contrast to it, defined contribution plan can be designed so to reward participants for working additional years beyond the Normal Retirement Age, instead of encouraging early retirement. What concerns cost variability risk, under defined benefit plan the employer faces investment risk and pre-retirement inflation risk. In such a way, in contrast to defined contribution plan, annual defined benefit plan costs are relatively difficult to predict. In addition, in a booming stock market pension costs may reach zero as investment returns on contributions that were done in the past.
At the same time, under defined contribution plan the employer faces no significant risk, and overall annual plan costs are quite predictable. Yet, in contrast to defined benefit plan, the employer cannot derive benefit from a booming stock market or any other investment returns on plans assets. In summary it can be said that both plans have their own advantages and disadvantages. Defined contribution plan is quite easily understood by participants, and both employees and employers can derive benefit from positive investment results.
The participants of this plan also can choose how much they want to save (Arcade and Mellors). This plan also can be funded through payroll deductions and there can be lump sum distributions. At the same time, defined contribution plans imply high investment risks and it becomes quite difficult to build an effective retirement fund for employees who decide to enter it late in their lives. What concerns defined benefit plan, it can be recommended due to its cost of living adjustments and guaranteed retirement income security for the employees. Defined benefit plan also poses no investment risk for both, employees and employers and never depends on the participant's ability to make savings.
However, in contrast to defined contribution plan, defined benefit plan is quite difficult to understand by its participants and is not beneficial to workers who decide to leave before the retirement. Yet, nowadays many employers transition away from defined benefit plans, as this type of retirement plans is more costly and is more complex for the businesses to maintain. Adhering to defined benefit plan, the employer needs to maintain the account for the plan and to make decisions concerning investments to ensure the amount will be increasing. At the same time, a defined contribution plan is less costly, especially in the long run, and is much easier to manage as there are no investment risks. However, it should be taken into consideration that by choosing a defined contribution plan, the responsibility of investing is put in the hands of the worker. Works Cited Arcade, A.
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Moore, J. "Measuring Defined Benefit Plan Replacement Rates with Pen Sync. " Monthly Labor Review 127. 11 (2004): 57. Morris, E. "Defined Contribution: From Managed Care to Patient-Managed Care. " The Cato Journal 22. 1 (2002): 103. Oates, N. and C.
Brown. "Time to Rethink Your 401 (k) Plan? Pension Protection Act Allows Employers to Redesign Retirement Plans. " Journal of Accountancy 203. 5 (2007): 50. Poterba, J. "Employer Stock and 401 (k) Plans. " American Economic Review 93. 2 (2003): 398 - 404. Secure, P. "Evolution of Employer-Provided Defined Benefit Pensions. " Monthly Labor Review 114. 12 (1991): 16.
Turner, J. , L. Muller and S. Verma. "Defining Participation in Defined Contribution Pension Plans: Traditional Measures Appear to Overstate the Number of Participants in Defined Contribution Pensions; Using Data from the Survey of Income and Program Participation and the Social Security Am. " Monthly Labor Review 126. 8 (2003): 36. Wagenbrenner, A. "Score One for Small Pension Plans. " Journal of Accountancy 179. 5 (1995): 29.
Walker, D. "Employee Benefit Plan Audit Answers. " Journal of Accountancy 181. 6 (1996): 59. Wiatrowski, W. "Living with Defined Contribution Pensions: Remaking Responsibility for Retirement. " Monthly Labor Review 122. 2 (1999): 69. Wilcox, D. "Reforming the Defined-Benefit Pension System. " Brookings Papers on Economic Activity 1 (2006): 235. Zelinsky, E. "The Defined Contribution Paradigm. " Yale Law Journal 114 (2004): 451.
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Research essay sample on Retirement Planning Defined Benefit Vs Contribution
