I've often heard of these two types of pension plans offered by companies:
- Defined contribution (DC)
- Defined benefit (DB)
What are they and how do they differ? Is one better than the other?
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Defined Benefit - the benefit you receive when you retire is defined e.g. $500 a month if you retire at age 65. It is up to the plan administrators to manage the pension fund, and ensure that there is enough money to cover the benefits based on the life expectancy of the retiree.
Defined Contribution - the amount you contribute to the plan is defined. The benefit you receive at retirement depends on how well the investments do over the years.
Defined Benefit Plans:
Defined benefit plans are disappearing because of their high cost to the companies that provide them. When an employee retires, the company must pay his pension for the rest of his life, even longer if the pension includes a survivor option. Thus the company's financial burden grows as more employees retire.
By law, they must provide a fund that has sufficient resources to pay all present and future pensions. Low interest rates, such as we have now, place a greater burden on the amount that must be in these funds.
For these reasons, most companies, including large ones like IBM and Lockheed Martin, have discontinued their pension plans and provide only defined contribution plans.
Defined Contribution Plans:
These require the company to only make contributions while the employee is working. Once the employee retires, the company's responsibility ends. Usually these plans employ a 401K type savings plan for which the employee contributes and the companies matches some or all of that contribution.
Although a fully company paid pension plan is the best, it is now almost unavailable. The defined contribution plan, if it includes company matching, can be a viable alternative if the investments are chosen wisely and perform as expected. Of course, this is not guaranteed but is probably the best option that most working people have at this time.
As others have explained defined contribution is when you (or your employer) contributes a specified amount and you reap all the investment returns. Defined benefit is when your employer promises to pay you a specified amount (benefit) and is responsible for making the necessary investments to provide for it.
Is one better than the other?
We can argue this either way.
Defined benefit would seem to be more predictable and assured. The problem being of course that it is entirely reliant upon the employer to have saved enough money to pay that amount. If the employer fails in that responsibility, then the only fallback is government guarantees. And of course the government has limitations on what it can guarantee. For example, from Wikipedia:
The maximum pension benefit guaranteed by PBGC is set by law and adjusted yearly. For plans that end in 2016, workers who retire at age 65 can receive up to $5,011.36 per month (or $60,136 per year) under PBGC's insurance program for single-employer plans.
Benefit payments starting at ages other than 65 are adjusted actuarially, which means the maximum guaranteed benefit is lower for those who retire early or when there is a benefit for a survivor, and higher for those who retire after age 65. Additionally, the PBGC will not fully guarantee benefit improvements that were adopted within the five-year period prior to a plan's termination or benefits that are not payable over a retiree's lifetime.
Other limitations also apply to supplemental benefits in excess of normal retirement benefits, benefit increases within the last five years before a plan's termination, and benefits earned after a plan sponsor's bankruptcy.
By contrast, people tend to control their own defined contribution accounts. So they control how much gets invested and where. Defined contribution accounts are always 100% funded.
Defined benefit pension plans are often underfunded. They expect the employer to step forward and subsidize them when they run short. This allows the defined benefits to both be cheaper during the employment period and more generous in retirement. But it also means that employers have to subsidize the plans later, when they no longer get a benefit from the relationship with the employee.
If you want someone else to make promises to you and aren't worried that they won't keep them, you probably prefer defined benefit.
If you want to have personal control over the money, you probably prefer defined contribution.
My personal opinion is that defined benefit plans are a curse. They encourage risky behavior and false promises. Defined contribution plans are more honest about what they provide and better match the production of employment with its compensation. Others see defined benefit plans as the gold standard of pensions.