Question

Differentiate between a defined contribution pension plan and a defined benefit pension plan. Explain how the employer’s obligation differs between the two types of plans.

Answer 1

Defined contribution pension plan:
In this type of retirement plan, a company contributes certain amount (each period) to the retirement account of the employee. The employer's contribution depends on many factors like age of the employee, the number of years of service, compensation levels etc.

Defined benefit plan:
In this type of retirement plan, firm gives assurance to make regular payments to the employees after their retirement. The retirement benefits is determined by taking into consideration the number of years of service and the compensation given to the employee at or near the retirement of the employee.

Difference between the employer's obligation between the two plans:

In case of defined contribution plan, the obligation of an employer is to make certain contribution to the plan each period and the contribution is determined by considering many factors. The company does not make any promise to the employee concerning the plan's future asset value. The company leaves the investment decisions to the employee. The investment risk is borne by the employee.
In case of defined-benefit plan, the obligation of an employer is to make enough contribution each period so that it can provide the future benefits that it has promised to the employee. Hence, the employer is at risk if the contributions are not sufficient enough to meet the promised benefits.