Understanding Defined Contribution and Defined Benefit Plans

Provided by Russell Investment Group

The two main types of employer-sponsored retirement plans offer ways to make your retirement more comfortable.

• Defined benefit (DB) - traditional pension plan that's been around since the 1920s  
 
• Defined contribution (DC) - relatively new type of pension plan that gives employees more control over and responsibility for their retirement benefit  

Defined benefit (DB) plans are run by the employer, who invests company assets to pay retired workers (and sometimes their survivors) a guaranteed regular income for the rest of their lives.

The employer bears the responsibility to meet this obligation, but gets to deduct the contributions made on your behalf from its tax bill.

The amount of this annual benefit usually is "defined" by a formula that takes into account an employee's earnings and years of service. Typically, the proceeds of a DB plan are distributed when the employee retires and cannot be transferred from one employer to another. Some, but not all, DB plan benefits are periodically adjusted for inflation.

• Employer pays for retirement benefit  
 
• Employer bears responsibility of investing money to reach benefit  
 
• Employee gets guaranteed benefit for life  

• Employee has very limited control over the size of the benefit  
 
• Employee must meet certain qualifications to receive benefit  
 
• Benefit typically isn't transferable from one employer to another  
 

Defined contribution (DC) plans can be offered by an employer or other organization (such as a union). These plans permit the plan sponsor and/or the employee to contribute money into an employee retirement account without promise of a specific retirement benefit.

This modified type of pension plan allows the employee (and the employer) to make a "defined" contribution to an employee retirement account that can be invested in a series of investment options. In this structure, it's usually (but not always) the employee who gets to choose whether to make contributions in the plan, how much money is contributed, how the money is invested, and how long it remains invested.

Some employers make contributions to an employee's DC plan account regardless of the employee's participation, and some plans place restrictions on how contributions can be invested. DC plan assets usually are "transportable," meaning the employee may take part or all of the money in their account with them should they change jobs before retirement. If you've met your vesting requirement, you also get employer contributions, plus any earnings.

• Employee can save and invest on a tax-deferred basis  
 
• Employee usually has significant authority over how much money is contributed to the plan, how it is invested, and how long it is invested  
 
• Plan assets typically are transportable from one employer to another (or another type of DC plan)  

• No retirement benefit is guaranteed  
 
• Employee assumes greater responsibility for generating a significant portion of their retirement income  
 
• Amount of retirement benefit dependent upon quality of employee's investment decisions  

A DC plan usually permits you to postpone or defer paying taxes on any contributions (employee and/or employer) made to your account. What's more, investment earnings grow tax-deferred, too. You don't pay taxes on this money until you withdraw it (usually in retirement), and you pay only on the amount withdrawn in a given year. You may have to pay certain tax penalties, however, if you withdraw money before age 59-1/2.

Chances are your DC plan offers a variety of investment options. This allows you to select investments that may match your financial objectives and reflect your comfort level with investment risk.

Regular contributions through payroll deduction let you develop a disciplined savings habit. Saving for retirement becomes easy and automatic.