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Defined Benefit vs. Defined Contribution Retirement Plans: Pros & Cons

If you draw a public or private pension along with Social Security, you are the beneficiary of a defined benefit. On the other hand, if you receive a monthly payout from a retirement plan that you (and perhaps your employer) contributed to, you are drawing from a defined contribution plan.


If your retirement planning incorporated both the defined benefit and defined contribution approaches, you planned wisely because both retirement plans have advantages that counterbalance their disadvantages.


Let’s explore both options.



retirement contributions

Defined Benefit Plan Advantages

Public and private pension plans are defined benefits. Their monthly payouts are based on years of service, the highest salary amounts received, and other factors. What defined benefit packages have in common is the longevity requirement and the fact that the employer contributes everything. Beneficiaries only have to stay with the company.


Beneficiaries also don’t have to worry about the pension plan's solvency, track how their pension account is invested, or worry about payouts. It’s all part of a compensation package that is another incentive to remain loyal to the employer for the long haul.


We mentioned Social Security as a defined benefit. Technically, it is, even though you fork over 6.2 percent of your salary, and your employer kicks in the same. Everyone pays a tax, leading to a defined benefit based on your earnings and when you decide to receive your monthly check.


Defined Benefit Plan Disadvantages

The main disadvantage of a defined benefit plan is that the employer often requires a minimum amount of service. Although private employer pension plans are backed by the Pension Benefit Guaranty Corp up to a certain amount, government pension plans don’t have the same, albeit sometimes shaky, guarantees.


Likewise, defined benefit packages can succumb to the pressures of costs and the volatility of investment markets. Defined benefit plan payouts have become less popular as a private-sector tool for attracting and retaining employees.


Defined Contribution Plan Advantages

Deferred contribution plans rely on employee contributions and can include employer-matching funds. The most common defined contribution plans are regular and Roth IRAs and 401(k) plans. With good planning, employees can set aside retirement savings, which they own and can transport from one job to another. The interest compounds over the years with deferred taxation.


One advantage is that the owner has more flexibility in investing and contributing to the plan. Then there are the immediate and deferred tax advantages, which can accrue with before-tax earnings (regular IRAs, for example) and after-tax contributions (for Roth IRAs). You are taxed when you withdraw the money in a lower tax bracket during your retirement.


Defined Contribution Plan Disadvantages 

The downside of defined contribution plans is that they require discipline and wise management. Life tends to shape our financial priorities away from the horizon of retirement planning and savings. Also, most people don’t have the expertise to invest. 


As you can see, each plan option has its pros and cons. Defined benefit plans incentivize employees to remain with the same employer, who assumes the risk and expenses. However, there are no guarantees that the plan will either exist or even offer the originally promised benefits in the future. Defined contribution plans give the owner full control and risks. However, poor savings habits and bad investments could result in zero retirement savings. 


Each type of retirement plan has its place in your retirement strategy. When deciding which basket to use to park your nest eggs, your best bet is to diversify, get good financial advice, and keep moving toward a comfortable retirement.



Invest In a Life You Love,

Donovan Carson - founder of Carson Capital




 

Donovan-carson-founder-carson-capital

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