Most employers offer a retirement plan as a benefit to their employees. To maximize the amount you receive for retirement from your employer, it’s important to understand the differences between defined-benefit and defined-contribution plans, down to the details of who makes contributions to the plan, the maximum contribution amount allowed, and if you can withdraw early.

What is a Defined-Benefit Plan?

Defined-benefit plans are often called pension plans, and are one form of employer-sponsored retirement benefits. The benefits and payout are often calculated with regard to how long you’ve worked for the company, your age when you retire, and your salary; there is no standard formula or method for calculating the benefits.

Defined-benefit plans are often designed to entice workers to stay with their company for many years. These plans include contributions the employer makes while the employee is employed, as well as contributions from the employee, though it is usually optional (and often rare) for the employee to contribute. The funds are managed by the employer.

The benefits are guaranteed so long as you have met the terms of the plan, which is different from 401(k)s, as that plan depends on fluctuating investments. In this sense, the financial burden of defined-benefit plans is on the employer rather than the employee. That said, employers typically receive tax breaks for participating in defined-benefit plans, even though they are on the hook for the payout to the employee, regardless of how well or how poorly the investments do.

Most defined-benefit plans have some level of protection from the Pension Benefit Guaranty Corporation.

Defined-Benefit Plan Payouts

Payouts for defined-benefit plans are typically made either as a lump sum or through an annuity which offers regular payments for the remainder of your life. Here are ways the payout can be structured:

• A single life payment provides a monthly payment every month until you pass away, with your beneficiaries unable to receive any further payments after your death.
• A single life with term certain structure will pay out monthly benefits for a named term; if you die before that term is over, your beneficiaries will receive the payment.
• Selecting a 50% joint and survivor payout allows your surviving spouse to monthly payments for half of the original annuity amount.
• With 100% joint and survivor, your spouse will receive monthly payouts for 100% of the original annuity.

What is a Defined-Contribution Plan

With a defined-contribution model, the employee (and sometimes the employer, in a matching amount up to a certain percentage, usually 2 to 5%) makes contributions to the retirement plan, but the final payout depends on how the money was invested by the employee.

These plans come with significant tax benefits. The employee can exclude the contributions from their total taxable income for the year, or contribute to a post-tax Roth, allowing for tax-free income during retirement. Because of these benefits, there are tax penalties (usually 10%) when you withdraw from your defined-contribution plan before retirement age (59½ years old), with very few exceptions.

Types of Defined-Contribution Plans

• 401(k): A standard defined-contribution plan, intended for private businesses.
• 403(b): Like a 401(k), but for employees of schools, nonprofits, and health care facilities.
• 401(a): Designed for government, educational, and nonprofit employees, these plans are structured so the employer can set unique eligibility requirements, contribution amounts, and vesting schedules.
• 457: For public-sector workers, such as state and municipal employees, as well as some nonprofits.
• Thrift Savings Plan (TSP): Intended for federal employees.
• Savings Incentive Match Plans for Employees (SIMPLE): For businesses with 100 or fewer employees.

What’s the difference? (Pros and Cons)

• With a defined-benefit plan, the employer is the main contributor; sometimes, but rarely, the employee will contribute, depending on the plan’s terms. With a defined-contribution plan, it is standard for both the employer and employee to contribute.
• Defined-benefit plans provide a guaranteed payout; these plans are offered less frequently due to the financial burden on the employer.
• Investment of defined-contribution plans falls on the employer; your plan can be moved when you leave your current place of employment, which can be useful if you don’t intend to stay at a job very long.
• Employer contributions to defined-benefit plans are usually fixed, while with defined-contribution plans the employer typically matches whatever the employee contributes, up to a certain percentage.

Final Thoughts

There are several factors that you must consider when deciding between a defined-benefit and a defined-contribution plan, if you are fortunate to have the choice at all. If you prefer flexibility, a defined-contribution plan might be a better choice. If you need to guarantee a certain amount for your retirement, a defined-benefit will give you that peace of mind, as your retirement won’t be dependent on market fluctuations. Finally, you might want the option to cash in on a defined-benefit plan as a lump sum to pay for a large expense.

If you have questions about your retirement plans, we’re here to help. It’s important to discuss all of these considerations and your personal priorities and goals with one of Retirable’s Certified Financial Planners®. Schedule your free consultation today.