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Pensions Explained

The Difference Between A Defined Benefit Pension And A Defined Contribution Pension Plan.

Article By : Patrick Mansfield | U.S. Gov Connect
pension explained

To understand your retirement benefits, it's important to familiarize yourself with the type of plan your employer offers. If your employer offers several retirement plans, they may have different participation requirements for each. No matter what type of retirement plan your company offers, it's important to understand the differences between the major types of plans: defined benefit and defined contribution.

Defined Benefit Plan:

A defined benefit plan is funded by your employer. Typically, this type of plan calculates your monthly benefits at retirement through a complex formula that takes into account your age, your salary and the number of years you've worked for your employer. For example, the formula may conclude that your benefits will be equal to one percent of your average salary during the last five years of employment multiplied by your total years of employment. In some cases, defined benefit plans may forego the typical formula and offer a set amount of benefits per month, such as $100 per month at retirement.

Defined Contribution Plan:

Unlike a defined benefit plan, a defined contribution plan does not offer a set amount of benefits per month. Instead, you and your employer contribute a certain amount to your account within the plan. Typically, you are responsible for determining how much money is put into the defined contribution plan each month and how those contributions will be invested. Sometimes, your employer will also contribute to your account by matching a percentage of your contributions.

One prime example of this type of plan is a 401(k.) There are four types of these retirement plans, including the traditional 401(k), the SIMPLE 401(k), safe harbor 401(k) and automatic enrollment 401(k) retirement plans. Additional examples of a defined contribution plan include the SIMPLE IRA plan, SEP, employee stock ownership plan and profit sharing plans.

How much you end up with when you retire will depend on some contributions to the plan and how well those investments performed. Once you retire, you will receive the full balance of your account.

Unfortunately, employers are not required to offer pension benefits to employees. However, the Pension Benefit Guaranty Corporation (PBGC) does guarantee payments for most individuals enrolled in defined benefit plans, provided the plan is canceled without enough funds to cover the cost of the benefits promised.
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