Defined contribution versus a defined benefit pension: Is one better than the other?
I have a huge announcement: I got a job!! One with stable hours, benefits, and a pension! No more casual hours or uncertainty for me. It feels incredible, but has also opened up new financial questions for me. I’ve never been in a position that has a pension before, so it’s an exciting new chapter in my life. I’ve been so heavily focused on my debt that retirement planning was heavily overshadowed. Now that pension deductions will be coming off my paychecks, I wanted to understand exactly what I get out of it. My guy was explaining how his plan works, and that’s when I realized there are different versions of defined pensions. So what is the difference between a defined contribution plan versus a defined benefit pension?
So, how does my retirement work?
I want to start by saying if you’re lucky enough to work for a company that offers any version of a pension plan, take a second to appreciate your good fortune! Many companies have moved away from offering any version of a pension because it can be costly for them. Pensions are extremely valuable to your future, so consider yourself lucky!
Secondly, if your position is eligible for a pension please take advantage of it. Saying no to contributions from your employer is literally like lighting free money on fire. You’ll be kicking yourself in 30 years. Apply for it, start contributing, and do your future self a massive favor.
In companies that offer retirement plans for their employees, they are typically divided into two types: a defined contribution plan or a defined benefit plan. They sound similar, but are actually quite different.
Defined Contribution Plan:
A defined contribution plan is one where the employee contributes a set percentage of money each pay period. Typically a company will then match that employees contribution.
For example, let’s say you make $100,000 yearly. If your company allows you to contribute 4% yearly with matching, that means you will have $4000 taken off you paychecks throughout the year, and your employer will match that by adding an additional $4000 into your retirement account. They’re giving you $4000 each year for free!! Say yes! By the end of year one, you would have $8000 in retirement investments not counting interest.
A defined contribution plan places the financial risk (and also possibility of larger reward) on the employee. If market returns on the investments are poor or negative, it will impact how much money you have available at retirement. All amounts contributed by you and your employer (plus interest on the investments) will become available to you at retirement. Since you get to decide how much to withdraw, you aren’t guaranteed a stable retirement income. If you take too much out or if the markets crash, you risk not having enough income to sustain your entire retirement. [If you want your retirement money to last forever read this]. However, if markets do incredibly you could end up with a larger amount available to spend than someone with a defined benefit pension.
Defined Benefit Pension:
A defined benefit pension sounds similar, but works much differently. With my new position, I will have a defined benefit pension (if you’re curious about my pension plan, check out LAPP)
With defined benefits, you will have a certain percentage of your salary deducted off each paycheck (your contribution into the plan). Once you retire, you will receive a guaranteed amount of money for as long as you live. Your monthly pension is not based on how much you contribute or how markets do; it’s based on an algorithm using how many years you work and what your average working salary is. The amount you will receive is guaranteed forever, so the financial risk is placed on the employer.
Even if the markets crash you are promised that amount of money until your death. Due to that, defined benefit pensions are often called the “safe pension” because you never have to wonder how much money you have. You can log into your account whenever you want, and see what your guaranteed monthly amount will be (market returns will have zero effect)
The longer you work for that company and the higher your average salary during your working years= a higher guaranteed amount in retirement.
Both are good.
Regardless of whether you have a defined contribution plan versus a defined benefit pension, you are lucky!! You’re working for a company that is helping to set you up for a stable and enjoyable retirement; take advantage of it. Many companies have workshops a few times a year that explain how their programs work. Contact HR and get them to send you further information or enrollment forms if you haven’t already done so. It’s a small step now for an incredible future. Do yourself a favor and opt in.
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