back to Today's Commentary
-- September 6, 2002
Q: With all the talk I've been hearing about pension funds lately, can you explain the difference between a defined benefit plan and a defined contribution plan?
A: The Employee Retirement Income Security Act (ERISA), which is the federal law governing pension plans in the US, divides retirement plans into two basic types: defined benefit and defined contribution plans.
A defined benefit plan, in essence, promises a specified monthly benefit at retirement. The plan may state this promised benefit as an exact dollar amount, such as $2,000 per month at retirement. More typically, it may calculate a benefit through a formula that considers such factors as salary and length of service with the company. For example, a plan may offer 1 percent of average salary for the last five years of employment for every year of service with an employer. The benefits in most traditional defined benefit plans are protected, within certain limitations, by federal insurance provided through the Pension Benefit Guaranty Corporation (PBGC).
A defined contribution plan, on the other hand, does not promise a specific amount of benefits at retirement. In this type of plan, the employee or the employer (or often both) contribute to the employee's individual account under the plan, sometimes at a set rate, such as 5 percent of annual earnings. These contributions generally are invested on the employee's behalf and, with varying limitations, at the employee's direction. The employee will ultimately receive the balance in the account, which is based on contributions plus or minus investment gains or losses. The value of the account will fluctuate due to the changes in the value of the investments.
Examples of defined contribution plans include 401(k) plans, 403(b) plans, employee stock ownership plans, and profit-sharing plans. The 401(k) plan is a common type of defined contribution plan in which employees can elect to defer receiving a portion of their salary, which is instead contributed on their behalf, before taxes, to the plan. Sometimes the employer may match these contributions. There is a limitation on the amount an employee may elect to defer each year.
ERISA requires plan administrators (employers) to give employees in writing the most important facts they need to know about their pension plan. Some of these facts must be provided to employees regularly and automatically by the plan administrator. Other facts are available upon request, free-of-charge, or for copying fees. If you have a pension plan with an employer, your request for information should be made in writing.