There are two main types of employer sponsored-retirement plans: Defined contribution plans and defined benefit plans. What sets the two apart are who is contributing to the plan and where the investment responsibility lies.
With defined contributions—the most common of which is the 401(k)—employees determine the amount they wish to contribute and direct how those assets are invested.
With defined benefit plans—commonly called pension plans—the benefit is paid by the employer based on factors such as compensation, age and tenure at the company. The company invests that money with the goal of paying the employee a “defined benefit” throughout retirement.
Over the past 40 years, defined contribution plans have come to dominate the landscape. (For more on 401(k) plans, click here). But as defined benefit plans have not entirely gone the way of the dodo and present a different set of considerations, they deserve our attention.
Here’s a concise overview of what to know about this type of retirement benefit:
- The Risk. In a defined benefit plan, an employer invests to grow assets to accumulate a retirement benefit for each employee. The big risk is that they are unable to pay out as much as they promised—either due to a lack of funding, poor investment results or the company goes out of business. This is why we commonly recommend that investors consider making contributions to another retirement savings account, like an IRA (individual retirement account), and not pin all their retirement income hopes on a pension plan or Social Security.
- The Payout. The benefit is usually paid to the employee at a predetermined age as an annuity with two payout options decided upon by the employee. The single-life option guarantees a payment to the employee as long as they live. Whereas, the joint-survivor option continues to pay out to a spouse for their lifetime should the original pensioner pass away. The joint-survivor option typically pays a lower annual amount for the additional benefit.
- The Rollover Potential. In some cases, employees can opt to take a lump sum from their pension and roll it into an IRA upon retirement; this is often presented as a choice alongside annuity options. A rollover may make sense if you want more control over how you access the money or if you want to try to grow the assets more aggressively over time. (We can help you make the appropriate decision based on your circumstances and needs.)
In concert with a defined contribution plan or an IRA, defined benefit plans can be an effective way to help you save for retirement.
If you are offered a defined benefit plan through your employer, we can review how it fits within your overall financial plan. If you are a business owner who wants to understand how a defined benefit plan can help your employees save for retirement and potentially lead to significant tax savings for you, please give us a call. We’re here for you.