There are two types of registered pension plans out there; defined benefit and defined contribution. Employers tend to offer one or the other.
What is the difference between the two? I anticipate many have asked the question.
Defined Benefit Pension Plan
The income you receive at retirement from a defined benefit pension plan is predetermined. Meaning, when you retire you are entitled to a certain level of retirement income up until the date of your death. Your predetermined income amount is often calculated by a formula based on years of service and your earnings (salary).
The contributions to a defined benefit pension plan are usually made by both you (the employee) and your employer. The assets of the pension plan are often held separately from the assets of the corporation in a trust. This trust is managed in most cases by a professional asset manager who makes investment decisions on your behalf.
If a defined benefit pension fund does not have enough money to cover retirement income pension liabilities then the company is on the hook for funding the gap. This is recorded on the company’s balance sheet as an unfunded pension liability. In general, defined benefit pension plans are more costly for companies because they do shoulder the risk if there is a funding deficit.
Some defined benefit pension plans do index your retirement income entitlement to inflation.
Defined Contribution Pension Plan
The income you receive at retirement under a defined contribution pension plan is not predetermined. Meaning, when you retire, you are entitled to a level of retirement income up until you run out of money in your account. The income you receive in retirement is based on the contributions made over the years and the investment income generated on those contributions.
Contributions to a defined contribution pension plan are made by your employer and sometimes by you the employee. The amount of contributions made are generally based on a percentage of your salary or a specific dollar amount. All contributions under a defined contribution pension plan are deposited into an account under your name.
Investment decisions for the contributions made to the account in your name are often directed by you (the employee), based on your specific retirement timeline, specific retirement income needs and risk tolerance.
Summarizing The Two Main Differences
Retirement income under a defined benefit pension plan is predetermined where retirement income under a defined contribution plan is not. Under a defined benefit plan you continue to receive your retirement income entitlement up until the time that you die, where under a defined contribution plan you receive retirement income entitlement up until there are no more funds in your account.
With a defined benefit pension plan investment allocation decisions are made on your behalf by the professional asset manager of the pension plan trust. In contrast, under a defined contribution plan you are able to make your own asset allocation decisions based on your own retirement income needs and investing tolerances.