Written by Today, we’ll be discussing what is the difference between a defined benefit plan versus a defined contribution plan? When it comes to investing for your retirement. Most of us are going to have the choice of what is called a defined contribution. And that is going to be your 401(k) for most of you.
And for some of you who are in the public sector or maybe your government job. That’s going to be your 403(b). These are named after the tax codes that they’re referencing. Long story short, a defined contribution means you contribute.
Take advantage of the free money
You give money to your retirement account and most employers are going to offer a match to a certain percentage. It is very common to have a match up to 3%. It’s becoming more common where they give you maybe a half percent. For each percent you invest up to a certain number, like 5%. Either way you have the ability to access free money through the match. And then you get to choose your own retirement plan.
Retirement Choice
When it comes to choosing your retirement and designing it, having control over it is pretty good. You are able to decide whether you want to be aggressive when you’re younger. Or whether you wanna be more conservative as you get older. So one common approach is to say whatever age you are, that’s the percentage of your money that needs to be safe.
That money either needs to be in bonds, in a low risk vehicle. Or it needs to be out of the market. entirely So under that methodology, you’ll take a 30 year old and they would have 30% of their money saved outside of the market. Somewhere that’s safe in a bond of some kind. They would have 70% of their money still allocated in the stock market aggressively, looking for a return. When their 50 years old, then they would save 50% of their money is safe and 50% of the money is invested aggressively, still in the stock market.
When you’re 70, that you would have a 70% of your money safe and then 30% of your money would still be invested aggressively in the stock market.
The benefit of a defined contribution plan
The benefit of a defined contribution plan is your employer gives you that money today. You can then decide whether you want it to be invested aggressively, or you want it in something safer. On the other hand, if you have a defined benefit plan where it’s not a contribution where there’s something put in, but is a benefit, it’s something that’s given out. This is more commonly called your pension plan.
Retirement options
If you have a pension, that means that you’ll have options when it comes to retirement. You would either get a certain amount of money every single month for the rest of your life like an annuity. Or you would have the ability to get one large lump sum. In Florida, we have the Florida Retirement System where teachers and different government employees have the option of going into Drop and getting a large lump sum. Or they have the ability to get a pension where you get a certain amount of money for the rest of your life, every single month. Because they pension in an annuity are structured in the same way.
Drop in employer pensions
It means the employer has much higher cost to maintain a defined benefit plan. Which is why they’re not being offered that much. In a defined benefit plan, because you’re going to pay someone the rest of their life. You have to pay an actuary to tell you how long that person’s going to live. If you don’t know how long the person’s going to live, then there’s no way for you to figure how much money you need to have. So the extra cost of maintaining this is why a lot of employers don’t offer to find benefit plans anymore.
Single life
Another way a pension is designed just like an annuity is when you get to decide how you’re going to get the money out. They usually give you the three tiered options. You have the individual where it’s just based on your life, which normally gives you the highest amount of money per month. It’s just based on your life. It doesn’t take into consideration a spouse or a child or anything like that.
Period certain
The second option for most pensions is going to be a period certain option. And what that means is, is based on your life. However long you live, you will get that money for the rest of your life.
But if something happens to you within, let’s say the first 10 years of your pension, then it’s going to pay your spouse or a loved one for at least that first 10 years. That is a period certain, where it’s a certain amount of time that the pension is going to pay out no matter what. This option, because it changes the risk. Where it’s not just whether you live, but whether your spouse or your child lives.
That one, they would be more likely to offer you let’s say $1,500 a month. If you just had it based on your life, they’d give you $2,000, a month because you are taking all the risk. The second option would be $1,500 a month, because while there is some risk for the employer in the insurance company, you still are sharing some of the risk.
Joint life
The third option is where the employer takes all the risk. And it’s usually called a joint life option. Based on your life, it’s going to pay you that same amount, the rest of your life. But if something happens to you, it’s also going to pay your spouse the rest of their life. This is why that option may only be a $1,000 a month.
If you have the joint life, then they’re going to offer you a $1,000 a month. But If you have a period, certain where it’s your life and then maybe 10 years, just in case something happens to you, that’s $1,500 because you’re sharing some of the risk. If it’s just based on your life, you have all of the risk, so they’ll offer you $2,000. That’s how most annuities are structured. That’s how most pensions are structured. While some of the pluses of a defined benefit plan is you don’t have to worry about figuring out your monthly income. Or how you’re going to invest the money because the money is going to be there for you in retirement.
Risks of an employer pension
The downside is you’re putting a lot of trust in your employer. On the one end, you’re expecting the employer to be around when you retire. And if they’re not around, then your pension is gone. You have to figure out something else for retirement. On the other end, because you don’t have the money today. And you don’t get to choose how to invest it.
That means your employer is choosing how to invest the money. If they do a great job, then they fund the pension just fine. If they do a horrible job and lose money over the years, they may not have any money to fund your pension. And they do a horrible job running in the company. They may have to file bankruptcy and again, they won’t be there to fund the pension.
So you are putting a lot of trust in your employer that they’re going to be around. And they’re going to do a good job of allocating the money.
Defined contribution plan
In a defined contribution plan where you get the money today and then you get to allocate it. Even if the employer isn’t around that money is yours. You will get to take that 401(k) or that 403(b) with you onto your next adventure.
From an employer’s perspective, it is much more cost effective for them to offer a defined contribution plan. All they have to do is make sure you have the options available. They generally are going to give you a aggressive option, a moderate option, and a pretty conservative option. Then it’s up to you to decide how to allocate the money.
Once they give it to you, they don’t owe you any sort of a return. If you do a great job, good for you. If you do a bad job, bad for you. They don’t have to worry about paying actuaries and all these people to figure out how long you’re going to live. They don’t have to pay any fund managers to figure out how to invest the money.
Why employer’s like them
That is a much lower cost for them, which is why a lot of employers offer defined contribution plans. When it comes to the defined benefit plan. It is very costly for employers, which is why they don’t offer it as much. Not only do they have to deal with the risk of how to invest your money so that they can make more than the pension they’re paying you.
They also have to pay the actuaries to figure out how long you’re going to live. And they usually have contracts with insurance companies and with investment firms to figure out how to make the revenue they need, and also how to make sure they’re offering the right amounts to make sure that they don’t run out of money.
You’ll find that most private benefit plans are offered from the public sector. So most people that have government jobs you’ll find that the private sector generally is going to offer defined contribution plans.
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