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Defined-Contribution Plan Vs. Defined-Benefit Pension Plan

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There are two types of employer-sponsored retirement plans: defined-benefit pension plans and defined-contribution plans.

As the names imply, a defined-benefit pension plan provides a defined payment amount when you retire based on a formula and you know in advance what this formula is, and therefore what the amount would be. On the other hand, a defined-contribution plan grants employees the opportunity to contribute funds over time to save for their retirement and the employer provides matching contributions to a certain amount.

This means that defined-contribution plans are funded mainly by you… the employee. A portion of your salary gets taken out of your pay-check and set aside in your retirement plan for when you retire. Usually your company will match the contribution.

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The amount that you contribute (matched with your employer’s contribution) is then invested, at the employee’s direction, in select mutual funds, annuities, money market funds, or other financial options offered by the plan.

Because you, the employee, is responsible for directing the contributions and investments, these plans require little work and are low risk to the employer. Your employer has no obligation toward the account’s performance after the funds are deposited.

Alternatively, a defined-benefit pension plan has your employer taking a lot more of the risk and promising a specified pension payment amount when you retire. This is referred to as your pension’s “commuted value“. The great thing about defined-benefit pensions is that employers guarantee a very specific retirement benefit amount for each participant in the plan.

To learn more about what a defined-benefit pension plan is and the pros and cons of that type of plan, click here.

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