Many people when planning for retirement will have some type of retirement account sponsored by their employer as a part of their comprehensive retirement planning strategy. When it comes to retirement planning, there are two main types of employer-sponsored retirement plans: defined contribution plans and defined benefit plans. While defined contribution plans, such as 401(k)s, are more commonly offered today, defined benefit plans have been the traditional retirement plan for many workers.
What is a defined benefit plan?
A defined benefit plan, also known as a pension plan, is a retirement plan in which the employer promises to pay a specific benefit amount to the employee upon retirement. This benefit amount is typically based on a formula that takes into account the employee’s salary, years of service, and age at retirement. The employer is responsible for contributing enough funds to the plan to ensure that there is enough money to pay these promised benefits.
An employer takes on market risk
One of the key advantages of a defined benefit plan is that the employee does not have to worry about investment performance or market fluctuations. Instead, the employer takes on the investment risk and is responsible for ensuring that there is enough money in the plan to pay the promised benefits. This can provide a sense of security and stability for employees, as they know exactly how much they will receive in retirement.
Higher benefit amounts
Another advantage of a defined benefit plan is that the benefit amount is typically higher than what can be achieved through a defined contribution plan, such as a 401(k). This is because the employer is responsible for funding the plan and is required to contribute enough money to ensure that the promised benefits can be paid. In contrast, with a defined contribution plan, the benefit amount is based on the employee’s contributions and investment performance, which can be more unpredictable.
Increasingly rare
On the other hand, there are also some disadvantages to defined benefit plans. One is that they are becoming increasingly rare in the private sector, with many employers opting for defined contribution plans instead. This is because defined benefit plans can be more expensive for employers to fund and maintain. Also, these types of plans come with more regulatory requirements and oversight.
Less portability
Another disadvantage is that defined benefit plans are often less portable than defined contribution plans. This means that if an employee leaves their job before retirement, they may not be able to take their pension benefits with them. In contrast, with a defined contribution plan, the employee owns the account and can take it with them when they leave their job.
Understand the pros and cons
While defined benefit plans can provide a sense of security and stability for employees, they are becoming increasingly rare in the private sector and are often less portable than defined contribution plans. It is important for employees to understand the pros and cons of each type of retirement plan and to choose the one that best fits their individual needs and goals. An experienced financial advisor can assist you in navigating the process of integrating whatever retirement plan works for you into your overall wealth management strategy.