Defined-benefit retirement plan (DB) is a plan in which the computation of an employee`s benefits is done by use of a formula while considering such factors such as their earning`s history, age and service tenure (Defined Benefit, 2012). On the other hand, Defined-contribution retirement plan (DC) is one in which contributions are made by the employee and employer regularly but there is a fluctuation of future benefits based on investment earnings (Defined Contribution, 2011). Some of the Key characteristics of the DB plan include its purpose as an insurance program where it insures against income loss in the case of retirement, disability or death; the employer promises to pay a given benefit in case death, disability or retirement occurs; a mathematical formula is used to calculate the benefit amount and the benefit is unavailable during active service (Defined Benefit, 2012). Conversely, the DC plan serves as a savings accumulation program in which savings accumulate through investment earnings and deferred compensation; the employer promises to make periodical contributions to each employees account, the plan benefit is based on accumulated contributions and plan loans are available in some plans (Defined Contribution, 2011).
The two retirement plans differ in terms of the employers responsibilities in the plan administration. For instance, while an employer in a DB plan pays specific benefit based on age, pay and members service, in a DC plan, the employer contributes periodically and the amount may vary based on age, pay, service or employees contribution. Also, in a DB plan, the employer is responsible for contributing the promised benefits regardless of their costs while considering the investment returns. In a DB, the employer is expected to contribute periodically based on the amount promised to each employees account (Ilmanen et al., 2017).
Of the two retirement plans, the DB is riskier for an employer due to the unpredictable nature of the expected employer contribution. This is in comparison to the DC plan in which employer contributions can be adjusted appropriately to the current financial conditions. For an individual employee, a DC plan is riskier. This is because if a member withdraws their account balances in installments or a lump sum, they may outlive their benefits (Munnell, 2006). Also, in this plan, early retirees do not get an increase in their account balance while full actuarial reduction is implicitly applied. In DB, an employee enjoys a promised benefit and hence more security. Further, a DB retirement plan provides the individual employee with more resources at the end of their employment as it offers more value at a lower cost.
Ones payments commence under each of the two retirement plans, there are various personal income tax considerations for individual employees. According to Ilmanen et al. (2017), under the two plans, employee tax considerations are similar whereby members do not pay taxes on their employer contributions, retirement plan assets capital gains, or investment income until benefits are received. Therefore, the key tax considerations for individual employees under both plans include whether the benefits have been received by the employee and the benefit payment form rather than the retirement plan type.
Defined Benefit and Defined Contribution Retirement Plan Simulations. (2012). China-USA Business Review, 11(06). doi:10.17265/1537-1514/2012.06.010
Defined Contribution Plan Effectiveness. (2011). The Retirement Plan Solution, 191-200. doi:10.1002/9781118266878.ch20
Ilmanen, A., Kabiller, D. G., Siegel, L. B., & Sullivan, R. N. (2017). Defined Contribution Retirement Plans Should Look and Feel More Like Defined Benefit Plans. The Journal of Portfolio Management. doi:10.3905/jpm.2017.2017.1.064
Munnell, A. H. (2006). EmployerSponsored Plans: The Shift from Defined Benefit to Defined Contribution. Oxford Handbooks Online. doi:10.1093/oxfordhb/9780199272464.003.0018
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