Pensions and Defined Benefit Plans
Pensions and Defined Benefit Plans

What is the difference between a defined benefit plan and a defined contribution plan?

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Wolfgang Flamisch—Corbis

A defined benefit plan, most often known as a pension, is a retirement account for which your employer ponies up all the money and promises you a set payout when you retire. A defined contribution plan, like a 401(k) or 403(b), requires you to put in your own money.

Because defined benefit plans are more costly for employers than defined contribution plans, most of them have – you guessed it – scaled back dramatically or eliminated these plans altogether in recent years. If you still have a defined benefit plan at your company, consider yourself lucky.

In general, defined benefit plans come in two varieties: traditional pensions and cash-balance plans. In both cases, you just show up for work and, assuming you meet basic eligibility rules, you’re automatically enrolled in the plan. (In some instances, however, you aren’t enrolled until you’ve completed your first year on the job.) You also need to stick around on the job for several years – typically five – to be fully “vested” in the plan. The difference is in how the benefits are calculated; in a pension, it’s based on a formula that takes into account how long you were on the job and your average salary during your last few years of employment. The cash-balance plan credits your account with a set percentage of your salary each year.

Another key difference: If you leave the company before retirement age, you may take the contents of your cash-balance plan as a lump sum and roll it into an IRA. A traditional pension isn’t portable.

Some employers offer both defined benefit plans and defined contribution plans. If yours does, you should definitely participate in the defined contribution plan as well. That’s because more often than not, the amount of your defined benefit plan won’t be enough to allow you to live comfortably in retirement.

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