In all the discussion about retirement plans, pensions, 401(k)s, IRAs, you may have heard the term “defined-benefit” and “defined-contribution” plan thrown around and wondered what they meant. Both are employer-sponsored retirement plan types but have slight different characteristics.
A defined benefit plan, often called a “qualified benefit plan” or “non-qualified benefit plan,” is an employer sponsored retirement plan where an employee’s benefits are calculated based on an equation using employee factors, such as one’s salary history and length of employment. Under these plans, all the management functions of the plan are handled by the company and they alone bear the risk of their decisions; employees simply get paid out according to the schedule of the agreement.
(In the case of qualified benefit plans, the qualified refer to tax-qualified and the difference is that those plans have added tax incentives. Non-qualified benefit plans do not get these tax incentives)
Pensions are a common form of defined-benefit plan. Many pension equations include a growth rate tied to the results of the investments decisions made by the plan, but if the decisions result in negative results you will often see companies dip into earnings to fund pension shortfalls.
Whereas a defined benefit plan defines the benefit an employee receives, through a calculated equation, a defined-contribution plan only defines the front side of that equation. It’s an employer sponsored plan in which a specified amount or percentage is set aside for an employee. In these plans, the investment decisions may or may not rest in the hands of employees.
401(k) and 403(b) plans are common forms of defined-contribution plan. With a 401(k), your employer agrees to match your contributions up to a certain amount or simply contribute a percentage of your salary each year. In the case of many 401(k)s and 403(b)s, investment decisions and risks are for the employee to make and bear.