What is a defined-benefit plan?

A Defined-Benefit Plan is a type of employer-sponsored retirement plan that guarantees employees a specified level of retirement income based on a predetermined formula. In a defined-benefit plan, the employer bears the investment risk and is responsible for funding the plan to ensure that retirees receive the promised benefits. The benefit amount is typically based on factors such as the employee’s years of service, salary history, and age at retirement. Once an employee retires, they receive a regular pension payment for the rest of their life, often adjusted for inflation. Defined-benefit plans provide employees with a predictable and stable source of retirement income, regardless of investment performance or market fluctuations. However, these plans require careful financial management by employers to ensure that there are sufficient funds to meet future benefit obligations.

What is the difference between a 401k and a defined-benefit plan?

The main difference between a 401(k) plan and a defined-benefit plan lies in how retirement benefits are determined and managed:

1. Benefit determination:
• 401(k) plan: In a 401(k) plan, employees contribute a portion of their pre-tax income to individual retirement accounts, and employers may match a portion of these contributions. The eventual retirement benefit is based on the contributions made by the employee and any investment returns earned on those contributions over time. The employee bears the investment risk, and the retirement benefit is not guaranteed.
• Defined-benefit plan: In a defined-benefit plan, retirement benefits are predetermined and typically based on factors such as the employee’s years of service, salary history, and age at retirement. The employer bears the investment risk and is responsible for funding the plan to ensure that retirees receive the promised benefits. The retirement benefit is guaranteed by the employer, providing employees with a predictable and stable source of retirement income.
2. Employer responsibility:
• 401(k) plan: In a 401(k) plan, the employer’s primary responsibility is to administer the plan, select investment options, and possibly provide matching contributions. However, the employer does not guarantee a specific retirement benefit, and the eventual retirement income depends on factors such as investment performance and contribution levels.
• Defined-benefit plan: In a defined-benefit plan, the employer is responsible for funding the plan to ensure that there are sufficient funds to meet future benefit obligations. The employer bears the investment risk and must contribute enough to the plan to cover the promised benefits, regardless of investment performance or market fluctuations.
3. Portability and flexibility:
• 401(k) Plan: 401(k) plans are typically portable, allowing employees to take their account balances with them if they change jobs. Employees have flexibility in choosing their investment options and can control their contribution levels.
• Defined-benefit plan: Defined-benefit plans are generally less portable, as benefits are based on factors such as years of service with the employer. Employees have less control over their retirement benefits and may have limited flexibility in adjusting contribution levels or investment choices.

Overall, while both 401(k) plans and defined-benefit plans offer retirement benefits to employees, they differ in how benefits are determined, managed, and funded, as well as the level of risk and responsibility borne by the employer and employee.