An employer-sponsored retirement plan where employee benefits are sorted out based on a formula using factors such as salary history and duration of employment. Investment risk and portfolio management are entirely under the control of the company. There are also restrictions on when and how you can withdraw these funds without penalties.
Also known as "qualified benefit plan" or "non-qualified benefit plan".
This fund is different from many pension funds where payouts are somewhat dependent on the return of the invested funds. Therefore, employers will need to dip into the companys earnings in the event that the returns from the investments devoted to funding the employee's retirement result in a funding shortfall. The payouts made to retiring employees participating in defined-benefit plans are determined by more personalized factors, like length of employment.
A tax-qualified benefit plan, shares the same characteristics of a defined-benefit plan, but also provides the beneficiary of the plan with added tax incentives. These tax incentives are not realized under non-qualified plans.
Defined Contribution Plans:
A retirement plan in which a certain amount or percentage of money is set aside each year by a company for the benefit of the employee. There are restrictions as to when and how you can withdraw these funds without penalties.
There is no way to know how much the plan will ultimately give the employee upon retiring. The amount contributed is fixed, but the benefit is not.
Differences Along With Advantages and Disadvantages of Both Plans:
Defined Benefit Plans:
A defined benefit plan promises the participant a specific monthly benefit at retirement and may state this as an exact dollar amount. Monthly benefits could also be calculated through a formula that considers a participants salary and service. Unlike defined contribution plans, the participant is not required to make investment decisions. A defined benefit plan is sometimes referred to as a fully funded pension plan.
Advantages of Defined Benefit Plans
Guaranteed retirement income security for workers
No investment risk to participants
Cost of living adjustments
Not dependant on the participant's ability to save
Disadvantages of Defined Benefit Plans
Difficult to understand by participant
Not beneficial to employees who leave before retirement
More and more employers are moving away from defined benefit plans in favor of the defined contribution plan. Defined benefit plans are complex and very costly for the employer to maintain. The employer must maintain an account for the plan and decide the investments to keep the account growing. A defined contribution plan requires quite a bit of management by both the employer and the employee but is less costly to the employer in the long run. By choosing a defined contribution plan, the employer puts the responsibility of investing in the hands of the employee.
Defined Contribution Plans:
A defined contribution plan provides an individual account for each participant. The benefits are based on the amount contributed into the plan and are also affected by income, expenses, gains and loses. There are no promises of a set monthly benefit at retirement. Some examples of defined contribution plans include 401(k) plans, 403(b) plans, employee stock ownership plans and profit sharing plans.
Advantages of a Defined Contribution Plans:
Tax deferred retirement savings
Disdvantages of a Defined Contribution Plans:
Difficult to build a fund for those who enter late in life
Participants bear investment risk