A defined-benefit plan, or pension plan, is "free" in the sense that your company makes the entire contribution to the plan and must make sure that the investments make a profit. A defined-contribution plan, such as a 401(k) plan, is a retirement savings plan where you contribute money and your company matches all or a portion of what you contribute. Unlike a pension plan, you have full responsibility for investing the funds in your account. Pension plans provide guaranteed income from retirement until death, which can be attractive to older workers. Retirement savings plans have benefits that are more obvious, since the worker can see the balance grow over time, and the money is more portable, which can be attractive particular to younger workers.
A defined-benefit plan provides retirement security because it pays you a monthly benefit from the time you retire until either you or your spouse dies, whichever is later. The amount of the benefit is determined by a formula that combines salary and years of service. Your company makes the entire contribution to the plan each year and must make up for any shortfall due to investment losses. By law, a pension plan must be fully funded and the funds, can only be used to pay retiree pensions and health care expenses. Pension funds are protected from creditors in bankruptcy, and the accrued benefits are automatically insured up to certain limits.
It's difficult to predict how much money your company needs to pay you when you retire in the future. For example, if you die early, the company only pays a little. If you live a long time, it will pay more. As your salary increases, so does your pension. When interest rates are low, conservative investments don't add much to pension funds. By law, a company must hire an actuary to estimate the future pension liability and determine the current-year contribution the company needs to make to fund the plan. Actuaries use probability, statistics and advanced mathematics to make this determination.
In a defined-contribution plan, such as a 401(k) plan, you contribute a percentage of your salary to an individual savings account. Your company typically matches all or some of your contribution up to a maximum, often based on company performance. You control how your money is invested. When you retire, you can withdraw the money from your account up to the amount of your balance. If you leave a company, you can move your money to your 401(k) account at your next employer or roll it over into an IRA.
Companies are increasingly converting their pension plans to cash-balance plans. A cash-balance plan is a defined-benefit plan where each participant has a virtual account. Instead of paying an annuity until you die, your company determines your maximum benefit and pays you up to that amount in a lump sum when you retire. The company controls the investment of the funds, but you can take your virtual account balance with you when you change employers. Cash-balance plans are usually less expensive for companies because they provide a smaller benefit to older workers than a pension plan. However, they are more attractive to younger workers because, as with 401(k) plans, they provide an account balance and are portable.
- Jupiterimages/Brand X Pictures/Getty Images