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

As the names suggest, the major difference between a defined-contribution and a defined-benefit pension plan, lies in the distribution formula.

In defined-contribution pension plans, contributions are fixed and benefits vary depending on a number of factors, such as investment returns and earnings.

In comparison, defined-benefit plans contain a fixed desirable benefit which the contributions may vary in order to fund.

Types of Defined-Contribution Plans

Some common defined-contribution plans are as follows:

• A 401k plan is a modification of a pension or a profit-sharing plan, under which employers may elect whether to receive a cash bonus, or get a regular salary reduction to fund the plan on a tax-deferred basis. This plan helps avoid immediate taxation.
• Under money-purchase pension plans the employer is required to make fixed regular contributions to the pension plan. The contributions are then distributed among all the participants.
• Profit-sharing pension plans do not require from employers to make fixed annual contributions of a specified amount. The distribution of profits among participants must be pre-formulated by the pension plan.
• A target-benefit pension plan is of hybrid nature as it combines the characteristics of a money-purchase pension plan and those of a defined-benefit plan, the only difference being that there is a target benefit specified whose reaching is not guaranteed.

Characteristics of Defined-Benefit Plans

A defined benefit plan works in the opposite way to a defined contribution plan in that a specified retirement benefit is guaranteed. The benefit amount is based on years of service or the highest salary of an employee. Typically, defined-benefit plans are funded through deferred annuities, which are purchased every year.

Individual deferred annuities are an instrument of funding a defined-benefit plan on an individual basis. The premium rates are based on each participant's age and sex.

Another means of funding a defined-benefit plan, is through a group deferred annuity wherein the employees participate under a master contract provided by the employer.

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