By Ian Berger, JD
Fewer and fewer workers are participating in defined benefit pension (DB) plans these days. The high cost of maintaining those plans has led many employers to terminate existing plans and dissuaded many others from setting up new plans in the first place.
But there are still many DB plans out there, and it’s important to know that they operate very differently from defined contribution (DC) plans, like 401(k), 403(b) and 457(b) plans. Here are eight important differences:
1. Individual accounts. DC plans have individual accounts which hold employee deferrals, employer contributions and investment gains and losses on those contributions. DB plans (except for “hypothetical accounts” in cash balance plans) don’t have individual accounts.
2. How the benefit is determined. The amount of your DC plan benefit is simply the value of your account when you take your funds out. The amount of your DB benefit is based on the plan’s formula. A typical formula consists of three factors: (1) a multiplier; (2) the average of your highest annual salary over a certain period; and (3) your years of service with the company. For example, a DB plan may provide an annual benefit of 1.0% x average three-year highest consecutive salary x years of service.
3. Time of distribution. Many DC plans allow in-service distributions after age 59 ½ or hardship withdrawals (or both). Although DB plans can permit in-service payments, most do not.
4. Who contributes? Most DC plans allow employee deferrals and provide matching or other employer contributions. Most DB plans do not allow (or require) employee contributions. The participant’s benefit is typically fully funded by the company.
5. Amount of Contribution. The amount of contribution required by a DC plan sponsoring employer is determined by a set formula (for example, the matching contribution formula). By contrast, the amount of contribution required by a DB plan sponsor is calculated by the plan’s actuary based on a number of factors designed to ensure that the plan is properly funded.
6. Vesting. Employee deferrals to a DC plan are immediately 100% vested, but employer contributions can be subject to a vesting schedule. The schedule can be either “cliff vesting” (where contributions are unvested until they become 100% vested after three years of service) or “graded vesting” (where contributions are 20% vested after two years of service, 40% vested after three years of service, and so on). Most DB plans use a 5-year cliff vesting schedule.
7. Investment Risk. In most DC plans, the participant typically elects how her account will be invested from among options selected by the employer. In a DB plan, the company is responsible for investing plan assets.
8. Benefits guarantee. DB benefits are guaranteed up to a certain level by the Pension Benefit Guaranty Corporation (PBGC), a quasi-government agency, in case a plan is terminated without enough assets to pay out all benefits. DC benefits have no similar guarantee.