If you are drawing a public or private pension along with Social Security, you are the beneficiary of a defined benefit. On the other hand, if you are receiving a monthly payout from a retirement plan that you (and perhaps your employer) contributed towards, you are drawing from a defined contribution plan.
If your retirement planning incorporated both the defined benefit and defined contribution approaches, you planned wisely, because both retirement plans have their advantages, which counterbalance their disadvantages.
Let’s explore both options.
Defined Benefit Plan Advantages
Public and private pension plans are defined benefits. Their monthly payouts are based on years of service, highest salary amounts received, and other factors. What defined benefit packages have in common is the longevity requirement and the fact that the employer contributes everything. Beneficiaries only have to stay with the company.
Also, beneficiaries don’t have to look after the solvency of the pension plan. They don’t have to track how their pension account is invested or worry about payouts. It’s all part of a compensation package that is another incentive to remain loyal to the employer for the long haul.
We mentioned Social Security as a defined benefit. Technically, it is, even though you fork over 6.2 percent of your salary, and your employer kicks in the same. It’s a tax everyone pays and it leads to a defined benefit, based on your earnings and when you decide to receive your monthly check.
Defined Benefit Plan Disadvantages
The main disadvantage of a defined benefit plan is that the employer will often require a minimum amount of service. Although private employer pension plans are backed by the Pension Benefit Guaranty Corp up to a certain amount, government pension plans don’t have the same, albeit sometimes shaky guarantees.
Likewise, defined benefit packages can succumb to the pressures of costs and the volatility of investment markets. Defined benefit plan payouts have become less popular as a private-sector tool for attracting and retaining employees.1
Defined Contribution Plan Advantages
Deferred contribution plans rely on employee contributions and can include employer matching funds. The most common defined contribution plans are regular and Roth IRAs and 401(k) plans. With good planning, the employee can set aside retirement savings, which they own and are transportable from one job to another. The interest compounds over the years with deferred taxation.
One advantage is that the owner has more flexibility in investing and contributing to the plan. Then there are the immediate and deferred tax advantages, which can accrue with before-tax earnings (regular IRAs, for example) and after-tax contributions (for Roth IRAs). You are taxed when you withdraw the money during your retirement years when you are in a lower tax bracket.
Defined Contribution Plan Disadvantages
The downside of defined contribution plans is that they require discipline and wise management. Life has a tendency to shape our financial priorities away from the horizon of retirement planning and savings. Also, most people don’t have the expertise to understand how to invest.
As you can see, each plan option has its pros and cons. Defined benefit plans are an incentive for an employee to remain with the same employer, who assumes the risk and expenses. However, there are no guarantees that the plan will either exist or even offer the original promised benefits in the future. Whereas defined contribution plans give the owner full control as well as risks. However, poor savings habits and bad investments could result in zero retirement savings.
Each type of retirement plan has its place in your retirement strategy. When it comes to deciding which basket to use to park your nest eggs, your best bet is to diversify, get good financial advice and keep moving with the times towards a comfortable retirement.