Defined Benefit vs. Defined Contribution Plans: Understanding the Differences

Both defined benefit (DB) and defined contribution (DC) pension plans offer various advantages to employers and employees. The features of each are generally distinct and quite different.

Defined Benefit Plans

In a defined benefit plan, each employee’s future benefit is determined by a specific formula, and the plan provides a nominal level of benefits on retirement. Usually, the promised benefit is tied to the employee’s earnings, length of service, or both. For example, an employer may promise to pay each participant a benefit equal to a percentage of the employee’s final five-year average salary times number of years of service at retirement, or the employer may pay a flat dollar amount per year of service. A defined benefit plan is typically not contributory— i.e., there are usually no employee contributions. And there are usually no individual accounts maintained for each employee. The employer makes regular contributions to the plan to fund the participants’ future benefits. The employer bears the risk of providing the guaranteed level of retirement benefits. In 1993, 56 percent of full-time employees of medium and large private establishments were covered by defined benefit plans (U.S. Department of Labor, 1994). Defined benefit plan sponsors may choose from several formulas for determining final retirement benefits.

These include:

  • Flat-Benefit Formulas— These formulas pay a flat-dollar amount for every year of service recognized under the plan.
  • Career-Average Formulas— There are two types of career-average formulas. Under the first type, participants earn a percentage of the pay recognized for plan purposes in each year they are plan participants. The second type of career-average formula averages the participant’s yearly earnings over the period of plan participation. At retirement, the benefit equals a percentage of the career-average pay, multiplied by the participant’s number of years of service.
  • Final-Pay Formulas— These plans base benefits on average earnings during a specified number of years at the end of a participant’s career (usually five years); this is presumably the time when earnings are highest. The benefit equals a percentage of the participant’s final average earnings, multiplied by the number of years of service. This formula provides the greatest inflation protection to the participant but can represent a higher cost to the employer.

Defined Contribution Plans

In a defined contribution plan, employers generally promise to make annual or periodic contributions to accounts set up for each employee. (Sometimes defined contribution plans are referred to as individual account plans.) The current contribution is guaranteed but not a level of benefits at retirement, as in a defined benefit plan. In 1993, 49 percent of full-time employees in medium and large private establishments participated in one or more defined contribution plans, up from 45 percent in 1988 (U.S. Department of Labor, 1994).

The contribution to a defined contribution plan may be stated as a percentage of the employee’s salary and/or may be related to years of service. Sometimes there are only employer contributions, sometimes only employee contributions, and sometimes both. The benefit payable at retirement is based on money accumulated in each employee’s account. The accumulated money will reflect employer contributions, employee contributions (if any), and investment gains or losses. The accumulated amount may also include employer contributions forfeited by employees who leave before they become fully vested, to the extent such contributions are reallocated to the accounts of employees who remain. These are called forfeitures.

There are several types of defined contribution plans, including money purchase plans, profit-sharing plans, 401(k) arrangements, savings plans, and employee stock ownership plans (ESOPs). These are described briefly below. (For more detail, consult individual chapters on these plans.)

Employee Benefit Research Institute, 1997