Part One: Defined Benefit Plans and Defined Contribution Plans
If you are planning to retire soon, there are some aspects you have to consider, like the age of retirement and the types of retirement plans that are available. A retirement plan is a financial arrangement set up by employers, insurance companies, the government or other institutions. They are designed to replace employment income upon retirement. In this article we will cover some types of retirement plans available in the U.S.
Retirement plans are classified depending on how benefits are determined, and they are either defined benefit plans or defined contribution plans. Other plans combine the characteristics of these two types of retirement plans.
Defined Benefit Plans
Defined benefit plans, also known as pensions, pay retirement benefits from a trust fund using a formula that considers factors like salary and service, and it is set by the sponsor of the plan. Less commonly, there are defined benefit plans that pay a specified monthly retirement benefit, and the plan promises the benefit as an exact dollar amount per month when retiring. As payments are made from a trust fund specially made for the plan, separate or Individual Retirement Accounts (IRAs) do not exist.
Benefits of defined plans are protected by federal insurance provided through the Pension Benefit Guaranty Corporation (PBGC). This usually applies within certain limitations and for the most traditional plans.
Most defined pension plans offered by the government and large businesses are “final average pay” (FAP) plans, which means that the monthly benefit equals the number of years of work multiplied by the person’s salary at retirement multiplied by a factor known as the “accrual rate”.
These plans can be funded or unfunded. If they are funded, contributions from the employer and participants are invested into a trust fund dedicated only to paying benefits to retirees under the plan. Plans must maintain adequate funding to be qualified.
If the plans are unfunded, no funds are set aside for the purpose of paying retirements benefits. The benefits will be paid immediately by contributions to the plan or by general assets. Nonqualified plans are unfunded, like Social Security.
Defined Contribution Plans
The main difference between these two types of retirement plans is that Defined Contribution Plans do have separate or individual accounts for each participant and they do not promise a specific amount of benefits at retirement.
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Defined Contribution Plans are employer-sponsored plans in which the retirement benefit of the participant depends on the amount of money contributed into the account and investment gains on those funds, less any losses or expenses charges. The contributions that were made into the account are invested and the returns of that investment are deducted from the individual’s account. Depending on the value of the investments, the value of the accounts will change.
When the person retires, his or her account is used to provide him or her retirement benefits, usually through the purchase of an annuity, which is a series of payments at fixed intervals that are paid while the person is alive.
Defined Contribution Plans have gained popularity recently and nowadays they are the most common among the private sector. This happens because a good number of employers see defined benefit plans as a financial risk and they prefer to offer defined contribution plans.
Some common defined contribution plans are Individual Retirement Arrangements (IRAs), 401(k) plans, 403(b) plans and profit sharing plans.