Compare and contrast defined contribution plans with defined benefit plans.
Under defined contribution plans, employers and employees make annual contributions to separate accounts established for each participating employee, based on a formula contained in the plan document. These formulas typically call for employers to annually contribute a given percentage of each participant's compensation. The most common types of these plans are profit-sharing plans, employee stock ownership plans (ESOPs), deferred 401(k) plans, and savings and thrift plans.
Under defined benefit plans, employees are guaranteed retirement benefits as spelled out in the plan document. This benefit is expressed in terms of a monthly sum equal to a percentage of a participant's preretirement pay multiplied by the number of years he or she has worked for the employer. The contributions an employer makes typically fluctuate from year to year.
Defined benefit and defined contribution plans differ in a number of ways. One difference is the likelihood an employee will achieve retirement income objectives. With a defined benefit plan, the employees know what amount of benefits they will receive upon retirement. With a defined contribution plan, employees will not know this in advance. Another difference is the cost of the two types of plans. With a defined contribution plan, employers know the plan's cost on a year-to-year basis; this is unknown with a defined benefit plan. A third difference is that although both plans are complex to administer, companies find that defined benefit plans are more burdensome.