Question

1. What are the main differences between a defined benefit pension and a defined contribution pension?

Answer 1

Defined benefit plan (DBP)is a retirement plan where the retirement benefit is defined well ahead. The amount of benefits that will be paid post retirement is computed   beforehand taking into account various factors like last drawn salary , number of years into service.

In a defined benefit plan , the pension amount is guaranteed, irrespective of the returns generated by the pension fund. Any Shortfall in the funds to contribute the promised defined contribution will be met by the Employer.

In a defined CONTRIBUTION plan(DCP), the pension amount is not known or pre defined as in the case of a defined benefit plan. Here the Contribution that is to be made for each term is fixed, not the payouts out of the pension fund. The actual payment of pension – may differ based on factors like the returns generated by fund. In a DCP the retirement benefits depend on the performance of the pension fund. There is no Guarantee or commitment to meet a shortfall if any from the Employer.

Thus the risk of Return on investments is borne by the employer in a DBP, and it is borne by the employee in a DCP.

Most of the DCP are funded by the employees-   the employers may or may not make a contribution towards such schemes.   Whereas in a DCB the employers do make their contribution and ensure the defined benefit is paid to the employees.

More over there can be a statutory limit to the amount of Contribution made under a DCP. Whereas there is no such limit for a DBP.

Under DBP there is no separate identity of the funds contributed towards a specific employee. The funds are pooled and managed to meet the Defined benefits of all the employees out of the pooled investment.

Whereas in a DCP the amount contributed and the returns on it is separately identifiable to the specific employee making the contribution and on whose name the account is.

The cost of maintaining a DBP is much higher when compared to a DCP. Since the DBP involves various cost like professionals to manage the funds to ensure guaranteed returns, Actuarial services by actuaries who make various estimates and projections etc.