While 67% of private industry workers had access to employer-provided retirement plans in 2020, only 52% had access only to defined contribution retirement plans. Just 12% had access to both defined-benefit and defined-contribution retirement plans. Wait a second. You mean there are different types of retirement plans and different ways in which you can contribute to them? Yep!
As if retirement planning weren’t already confusing enough, now you’ve gotta understand the differences between defined-benefit vs. defined-contribution. Sure, you might understand what “benefit” means, and you definitely understand what “contribution” means, but what do they mean in relation to your retirement account and the money you’re investing in it?
Follow along as we dive into the differences between defined-benefit vs. defined-contribution.
If you’re not really interested in an in-depth lesson on retirement accounts and contributions but know that you or our employees need retirement accounts, be sure to check out the Wealth Stack Growth Pack.
Defined-Benefit vs. Defined-Contribution Plan: Overview
When retirement accounts are employee-sponsored, they typically fall into one of two categories: defined- benefit or defined-contribution. And, it’s important to understand that the difference between a defined-benefit and defined-contribution plan is like night and day.
A traditional pension plan provides you with a guaranteed payment during your retirement. This is great for those who want to know exactly how much they can count on during their golden years. However, it can also have some serious drawbacks if employers stop contributing or workers don't save enough for their future needs.
This is what defined-contribution plans are for, essentially. They allow employees to contribute money on top of what their employer does, which works out pretty nicely because they are saving more quickly this way (just read up on compound interest!). However, with defined-contribution plans, much of the responsibility falls on the employee.
Defined-Benefit Plans Explained
Under defined-benefit plans, employers are solely responsible to pay workers their benefits. These programs are typically based on how many years the employee has worked with the company and what he or she makes at that time.
In short, these aren’t your typical employee-matched 401(k) plans. Instead, you’ll find quite a few defined-benefit plans in companies that are in the public sector, such as government jobs. Why aren’t they that popular? They’re complex to set up for the employer, requiring insurance for guarantees, which comes with higher administrative costs. And they don’t really benefit the employee long-term either as they have little control over the funds and what they’re being invested in. Unlike traditional 401(k) plans, for example, defined-benefit plans won’t grow exponentially if an employee decides to contribute more over the years.
However, it is important to mention that, just like other retirement plans, defined-benefit plans do offer some tax benefits. So, there’s that at least!
Summary: Defined-benefit retirement plans offer what the name states, a defined benefit that won’t change over the course of their retirement.
Defined-Contribution Plans Explained
Defined-contribution plans, in a nutshell, offer employees more flexibility and control over their retirement savings. In other words, employees have the freedom to choose what they do with their retirement savings.
In this case, the employee is responsible for making smart investments decisions over time. They'll need to ensure that they get the most out of their investments. And, they'll need to ensure they get the most out of the interest that builds on the account they’re investing in.
On top of this, it’s important to understand that defined-contribution plans are mainly funded by the employee. This occurs in the form of monthly paycheck deductions that go straight into the account. Employers, however, are able to make matching contributions up to a certain amount.
Sound familiar? Probably! A 401(k) is a defined-contribution plan. It’s the best example there is of this type of retirement account. What else is there to know about these types of accounts, though? For starters, employees are only able to contribute up to a certain amount each year. And, depending on which type of account they have, the money can grow tax-deferred until they withdraw it in retirement. Or, it can grow tax-free if the employee contributes with post-tax dollars. That’s the difference between a traditional and a Roth IRA, for example.
Summary: Defined-contribution plans are more flexible for both employers and employees. Employees can decide to invest however much they want up to a certain limi. This means that the contribution can remain the same. However, the benefit could grow over time depending on what they’re investing in.
Which is Better: Defined-Benefit or Defined-Contribution?
The short answer is: It depends.
Employers like defined-benefit plans because they promise to pay a certain amount of money to employees after they retire, and that amount won’t change over time (unless there’s another recession). That means employers don’t have to keep investing in their pension plans as much as they might if they had to offer a defined–contribution plan and provide employer matching contributions. However, unless you own a large business with hundreds of employees, managing the administrative aspects of a defined-benefit plan probably doesn’t make much sense.
Offering defined-contribution plans like a 401(k) or IRA isn’t actually that expensive in today’s day and age. And, employers are more likely to appreciate the ability to grow their wealth over time how they see fit, whether that means slowly contributing more and more each year as their salary grows or maxing out their contributions year after year.
Retirement Plans with Wealth Stack
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