The Two Key Areas of Employee Benefits – Pension Defined Benefits vs Pension Defined Contribution
Defined Benefit Plan
This is a fixed form of payment made to employees once they are retired. This is why they are also referred to as “fixed benefit” or “final salary” funds. This payment is usually calculated by a formula that considers three of the following aspects:
- The amount of salary you are paid at the time of retirement. (This can be an average of the salary you are being paid for last two to three years of service)
- Considering the number of years you have served as a member in the fund
- The accrual required for calculation purposes
The formula goes like this – your average salary at retirement (multiplied by) years in service (multiplied by) 2.2%
Advantages
This plan has no uncertainty. The member has the exact information of the pension he is entitled to at the end of his service. Moreover, the member feels free to invest in different investment plans without fearing the risk of uncertainty at the time of retirement.
Disadvantages
Unlike defined contribution benefit, there is no guarantee whether your pension will incorporate the effect of inflation or not. If it doesn’t, you will face quite a loss on the retirement pension plan.
Moreover, to have a significant amount of pension set for you at the time of retirement, it is very important that you have a good average salary throughout your service years. If not, you can have a very low amount set for you.
Defined Contribution Funds
The nature of these contributions is also fixed in different terms and therefore is also referred to as “fixed contribution” or “money purchase” funds. According to the funds specification, the contributions that the member is entitled to, do not guarantee the benefits of retirement.
However, there are certain aspects on which the benefits are dependent on. For example:
- The amount of contributions – contributed by the member and the employer
- The efficiency of the outcome of the investment plan
- Cost of administration
- The accumulation of withdrawal credits with the exemption of a member
- The consideration of annuity rates prevailing at the time of retirement
Advantages
Regardless of the uncertainty, there are chances that you receive higher pension than anticipated at the time of retirement. As a result of efficient investment performance, there is the likelihood that you receive a higher pension as compared to defined benefit pension.
Moreover, you can also expect to get the complete benefit if you change employment. You are also in a better position to make a choice between a range of investments. You do not have to worry about your average salary because the pension payment will not be determined on the basis of any formula.
Disadvantage
Uncertainty!! You can be left empty handed if your investment turns out to be a complete loss. This contribution plan is risky and requires proper know how before investment. In short, the pension depends entirely on investment and therefore members have no idea about the ultimate pension they will receive.
