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What is the difference between defined benefit and defined contribution?

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Quick Answer

The difference between defined benefit and defined contribution retirement plans is that the former is provides a fixed pre-determined monthly payout of benefits while the payout in the latter is variable, based on the contributions made by employers and employees as well as investment performance. The U.S. Social Security system is an example of a defined benefit plan, while a 401k is a type of defined contribution plan.

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Full Answer

A defined benefit plan, commonly called a pension or annuity, provides a percentage of the employee's base salary after retirement, dependent on the length of service with the company. Although employees typically pay into a defined benefit plan, the amount contributed does not directly bear on how much is received after retirement age, typically 65 years old. The most common type of this plan uses a "Final Average Pay" formula to calculate payout based on the employee's salary.

Defined benefit plans are generally either funded or unfunded. While the latter pays benefits to retirees directly from contributions of current employees, a funded plan collects contributions well ahead of payout, typically investing the pooled amount to increase return.

With defined contribution retirement plans, the burden of funding and risk is largely placed on the employee. Although many employers match contributions to these plans to a certain percentage, a large portion of contribution plans come from employee pre-tax earnings. These savings are invested, increasing amount over time based on prudent investment choices.

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