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What is the Difference between a Defined Contribution Plan and a Defined Benefit Plan?

Posted by Corey F. Schechter | Oct 13, 2016 | 0 Comments

Contributing Author: Dianne Schechter

There are two basic types of pension plans: defined contribution plans and defined benefit plans. Defined benefit plans are premised upon a guarantee by the employer that the employee will, at retirement, receive a specific benefit determined in advance by a pre-established formula, usually payable on a monthly basis. The employer's contributions are determined actuarially on the basis of the benefits expected to be payable. No funds are segregated for any particular employee, because defined benefit plans do not include separate accounts for each employee, nor does an employee have a specific percentage of the whole of the funds.

A defined contribution plan is one in which it is the contribution rather than the benefit that is the “known factor.” The benefit in a defined contribution plan is dependent upon the payments actually made into the plan together with the earnings on this money. The funds are segregated to the account of the employee.

Pension benefits are “vested” if the employee has an absolute unforfeitable right to receive a payment at retirement, even if the employee terminates employment prior to their normal retirement age as defined by the benefit plan. Vesting is usually based on a minimum requirement of time on the job in order for the employee to be eligible to receive a pension in any amount at retirement. The vesting schedule is typically incremental, with the benefits being fully vested at the end of a fixed number of years, but typically no greater than six years of service. Over the years, the monthly benefit will usually increase as a result of a number of factors, including seniority of the employee, salary and benefit increases, productivity, and inflation.

Pension benefits have “matured” when the employee is eligible to receive payments, generally at retirement age. It is often not possible to determine the maturity date in advance because employees may not be offered the option of accelerating or deferring retirement, depending upon the current needs of the employer, with a consequent effect upon the amount of the payment to be received.

Actual receipt of pension benefits that have not matured and that are not in pay status is almost always contingent upon a number of factors, such as the continued employment of the participant and whether the participant lives to retirement age. Whether or not the retirement benefits have vested is but one of the contingencies that the court must consider in making an equitable distribution award to a former spouse entitled to a portion of that benefit.

The specific amount of the benefit to be received at retirement will usually remain somewhat uncertain until the employee actually reaches retirement age. For example, the actual retirement benefit will frequently be dictated by the number of years of service, the highest salary earned by the employee (or an average thereof over a given number of years as provided in the plan's benefit formula), the election at retirement of a particular option for payment (for example, “single life,” or payment for the life of the participant with an annuity to be paid to a surviving beneficiary – discussed below) and, of course, whether the employee lives to retirement age and how long the employee lives thereafter.

Defined benefit plans assume payment of a predetermined pension benefit to the employee upon retirement during the remainder of the participant's life. Such plans often include a “survivor option” providing for a reduction in the benefit so that payments will continue to the surviving spouse subsequent to the employee's death.

For more information on the different types of benefit plans available to provide for you and your employees' sound financial future at retirement, please contact Corey F. Schechter who will be able to assist in establishing a benefit plan best suited to the needs of the company.

About the Author

Corey F. Schechter

Corey Schechter practices in the areas of Employee Benefits, Employee Stock Ownership Plans, Pension and Profit Sharing Plans, ERISA, ERISA Litigation, Business Law, Qualified Domestic Relations Orders (QDROs), and Employment and Labor Law.

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