Defined Benefit Plans versus Defined Contribution Plans

If you earn a living and consider planning ahead for retirement, you have likely heard the phrases “defined benefit plan” and “defined contribution plan.” However, while many people may see these terms, they may not fully understand the differences between these retirement income programs, even if they are enrolled in one type of plan. Make sure you are taking the necessary steps to plan for retirement and ensure that you have the income you need to support yourself and your family. If you are facing a possible job offer, you want to understand how to negotiate for the best retirement plan for your situation. Do not hesitate to discuss your retirement income with an experienced elder law attorney today.

Defined Benefit Plans

This type of plan is commonly called a pension. A defined benefit plan will offer you automatic payments after you retire, and the amount of those payments may depend on a formula that considers your years of employment with the company and your salary at the time of your retirement. Other types of defined benefit plans base the payment amount on the average salary for your last years of work. If you work longer and earn more, your pension payment may be higher.

No matter what the pension payout may be, a defined benefit plan involves a defined future payout. Based on the information you receive from your employer, you should be aware of the benefit amount to expect.

Employers often offer this type of retirement income plan to encourage employee loyalty. If you get a new job, you may also be giving up a guaranteed pension plan from your former employer, so it can be a selling point to stay with one company until retirement. However, this type of plan is less and less available among private sector employers in the United States, while remaining popular in the public sector.

Reports from the Bureau of Labor Statistics indicate the following:

• 26 percent of U.S. employees have the option of a defined benefit plan
• 86 percent of local and state government employees have the option of a defined benefit plan

However, many people fail to realize they may have access to a defined benefit plan without an offering by their employer. This is because Social Security is technically a kind of defined benefit plan. If you earn income and pay Social Security taxes, you should be set to receive a certain defined benefit amount when you retire.

Defined Contribution Plans

This type of plan requires an individual, an employer, or both to make contributions to a retirement savings account with no specific payout promise. Some well-known defined contribution plans include:

• 401K
• Roth 401K
• 403B
• Traditional IRA
• Roth IRA

401K and 403B accounts are employer-sponsored, while IRAs are not, so you do not have to work for a company to participate in this type of retirement plan. Your payment amount after retirement will depend on the amount you and/or your employer contributed and how your account did in the market. If you decide to leave an employer, you can take your account with you, unlike a defined benefit plan. However, the BLS report shows that only about 40 percent of the working population participates in this type of plan, which can be concerning when it comes to preparing for retirement.

Potential Pros and Cons

There are different possible benefits and drawbacks to each type of retirement plan, as follows.

Benefits of defined benefit plans:

• When an employer pays a pension as promised, there is no guesswork in retirement income, as you know what to expect and how to plan.
• There is no need to take a cut from your paycheck to contribute to this type of plan while you are working.
• The funds have protections against early withdrawal, which helps ensure the employee will have the funds for retirement.
• Employees do not need investment knowledge, as the employer manages the funds for them.

Benefits of defined contribution plans:

• There is the opportunity to save a significant amount for retirement if you properly use and manage this type of account.
• The account is yours, not your employer’s. This means you have the freedom to manage the account yourself and retain the funds if you change employers or become self-employed.
• These are tax-advantaged savings.

Downsides of defined benefit plans:

• You generally have to work at the same company for a long period of time for your pension to “vest.” If you leave, you lose access to those payments you may have earned.
• Pension accounts can be mismanaged, resulting in lower payments than promised. Private employers pay premiums to back their pension accounts up to a certain amount, though public employers do not.
• Many employers see eliminating pension offerings as a simple way to cut costs, especially since fewer and fewer companies offer defined benefit plans.

Downsides of defined contribution plans:

• Left to their own devices, many people contribute very low amounts or nothing at all to avoid cuts to their paychecks.
• Account holders may not properly invest or manage their accounts, leading to losses or stagnant dollar amounts.
• It is possible to withdraw funds early, which many people do despite the tax penalties.
• There are limits to how much you can contribute regardless of your earnings.

It is always important to carefully determine what the best tools for your retirement income may be and to diligently stick to a plan.

Consult Our New York Elder Law Lawyers

With pension plan availability dwindling, low participation in 401K-type plans, and threats to Social Security, many adults should rightfully be worried about their retirement income. Do not wait another minute to plan for your future and protect yourself financially. Schedule a consultation with a New York City elder law attorney who regularly helps clients plan ahead for the benefit of their finances, family, and own well-being.

At the law firm of Goldfarb Abrandt & Salzman LLP, we help clients with all aspects of retirement and estate planning. Please contact us online or call (212) 387-8400 today to learn more.