Defined Benefits Plans vs. Defined Contribution Plans
Company provision of employee retirement (or post-employment) benefits often takes one of two forms:
- Defined contribution (DC) plans
- Defined benefits (DB) plans
Defined Contribution (DC) Plans
DC plans outline the periodic amounts than a retirement plan sponsor (the employing company) contributes to the retirement plan and how those contributions are provided to employees.
- DC Plan Example: In the U.S., a common form of DC plan is the 401(k) plan, where the employer will contribute a percentage of the employee’s salary to the plan or will match contributions made by the employee. Each individual employee will have a personal account under the employer’s 401(k) and the employer must provide a range of investments, into which the employee can allocate his/her 401(k) funds. Commonly U.S. employers offer a range of mutual fund options to employees. Employees withdraw funds from their individual 401(k) plans after retiring, in order to pay for their living expenses.
- DC Plan & the Income Statement: Companies with DC plans will make annual contributions based on the plan’s formula and these contributions will be expensed as incurred.
- DC Plan & Cash Flows: the pension expense = cash outflow.
- DC Plan & the Balance Sheet: DC Plans do not create assets and liabilities, so the employer’s balance sheet is not affected.
- DC Plan Management & Risk: Under a DC plan, the employee assumes all retirement funding risk, as he/she must ensure that enough is saved to the account to fund retirement. Commonly, the employee makes the plan’s asset investment choices and losses due to asset value declines are absorbed by the employee.
Defined Benefit (DB) Plans
Under a DB plan, the employer/plan sponsor commits to providing a specified amount of benefits to employees after they retire. In the U.S., when someone refers to a “pension plan”, the individual is probably referring to a defined benefits plan.
- DB Plan Benefits Allocation: DB plans commonly allocate benefit amounts to employees based on factors such as the employee’s number of years with the company and the employee’s later years’ salary levels. Employees may be required to work for the company for some specified minimum number of years before they become “vested” in the plan and eligible for plan benefits.
- DB Plan Accounting: Compared to DC plan accounting, DB plan accounting is significantly more complicated.
- DB Plan Management & Risk: DB plans are managed by the plan sponsor, which is the employing company. The company must ensure that the plan is funded and promises made to employees represent a legal obligation that must be publicly reported on financial statements. Funding is the process by which the employer contributes assets into the DB plan. The amount that a company contributes to a DB plan is not the same as the DB plan’s expense.
- DB Plan Types (2): Most commonly, the DB plans are pay-related (1), whereby an employer will provide a regular pension check to retirees based on some past salaries. Less commonly, some DB plans are non-pay related (2), where the pension benefits is not based on historic employee pay. Non-pay related DB plans are rare.
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