Question

difference between defined contribution plan and defined benefit plan

Answer 1

Retirement plans can be categorized into two:

Defined Benefit Plans and Defined Contribution Plans.

A defined benefit plan seeks to provide a specified amount of payment while in retirement, whereas

a defined contribution plan requires employees and employers to contribute funds and invest it over a period to provide for retirement.

The major difference between these two categories of plans is whether, the employer or employee, who bears the investment risks and the cost of administering the plan.

Defined Contribution Plans

These are funded by the employee, who is ‘the participant’, the employer making matching contributions to a specified limit. The 401(k) plan is the most common defined contribution plan.

The participant makes a specified contribution from his salary with matching contribution by the employer up to a limit.

Where these contributions are invested is the employee’s choice which, can be in select mutual funds, money market funds, annuities or stocks offered by the plan.

As there is no obligation on the employer as to the performance of the fund after he has deposited his contribution, the employer has no risk at all with respect to the returns or payments from the fund.

Further, after deposit of the funds, the employer has no work at all, as it is the employee who directs the investments from the fund.

Defined Benefit Plans

Here, the employer guarantees a specific retirement benefit amount for each participant, which may be based on the employee's salary, years of service and a host of other factors.

As the payment by the employer is defined, the employer bears the entire risk as to investment of the funds and the employee has no role whatsoever other than making his contribution. The employer has to make good any shortfall in the fund as determined by actuarial methods.

The employer is responsible to administer the fund and hence has to do all the administrative jobs connected with the plan.