Defined Benefit vs Defined Contribution

*Updated for 2023*

It’s all in a name, right? If you have been around for any length of time you have most likely heard these terms before: defined benefit and defined contribution. And unless you speak in financial lingo, you probably have wondered what exactly these terms mean. No worries here – I’ll do what I can to clear up any confusion and present them in a way that’s applicable to the skilled trades. That’s why many of us are here, right?

It helps to know what exactly is going on in the retirement field to make informed and responsible decisions. After all, we are talking about the golden years when you will need to live off of retirement income at your disposal. The more you know, then, the better the decisions are and that is the hope here. Without further ado, let’s define and distinguish between the two so we can see the benefits and drawbacks of both.

Shore up your retirement house before it’s too late

Defined Benefit

First up is defined benefit. The definition is wrapped up in the name because when you think about a retirement account, it is the benefit that is defined. For example, chances are you know someone who retired from the military. They get a set amount of money – a defined amount – per month. Another defined benefit retirement plan is the nation’s largest: social security. Again, a senior citizen who draws income from social security draws a set amount per month – the set amount of money they get is their benefit and it is defined – hence defined benefit.

Essentially, then, a defined benefit retirement plan is one where the amount of money you receive in retirement is defined and spelled out. You know how much money you can count on per month when you retire because that amount has been defined.

Defined Contribution

Defined contribution, on the other hand, is vastly different in that it is NOT the benefit that is defined but the contribution that is defined. Think of the most popular retirement plan of today: the 401k. This retirement plan doesn’t spell out or define what it is you will get in retirement on a steady monthly basis. Instead, what is defined, or spelled out, is the contribution. This type of retirement plan is a defined contribution, where the amount of money you can contribute to it is defined, or spelled out. The IRS regulates how much you can contribute, hence the name.

From here on out in this article, when I use either term, you will see it like this: defined benefit (pensions) and defined contribution (401k/Annuity fund). Hopefully, this will help visualize what each term means by a real-world example.

*NOTE: I put 401k as one of the defined contribution plans because it is by far the most popular; it has become the retirement plan of choice for many employers. I have added Annuity fund because those of us who are covered under a collective bargaining agreement (union) have this type of defined contribution plan. I hope these plans attached to the type of retirement plan they are will help illustrate and connect the names of them.*

Which one is better?

Let’s compare and contrast – weighing each in the balance

So, the obvious question to ask is: which one is better?

The answer varies depending on not only your retirement needs but also the financial stability of the institution your retirement funds come from.

On the surface, the answer is quite simple: defined benefit, all day long. You get to receive a set amount of money for the rest of your life, money you can count on monthly. Who wouldn’t want that? There are other things to factor in, though, and we would do well to examine each of them to fully appreciate the different retirement plans. Let’s look at defined benefit (pensions) and defined contribution (401k/Annuity fund) to see how they compare.

Defined Benefit Negatives

Defined Benefit Negatives – what are they?

The main problem with defined benefit retirement plans (pensions) is for the past 50 years they have been systematically phased out. Companies used to offer pensions to attract and retain top talent but those days are long gone. I won’t bog down this post as to many of the reasons why this is so, I’ll just admonish you to check out the various links about pensions on the site for more information. It is in those posts where the details are and as we all know, the devils in the details.

Another problem defined benefit (pensions) retirement plans have is insolvency and underfunding, a very real problem for many to be sure. Suffice it to say, though, promised money is, well, promised. If you promise me something that is one thing; delivering on it is a different thing altogether.

The unfortunate reality for some is they failed to save any money on their own because they were relying on the promised money from a defined benefit (pensions) retirement plan. Because of problems they had nothing to do with, they find themselves struggling in retirement. The money they were promised is in jeopardy, dwindling, and in serious question.

I wish I could say this was just a hypothetical scenario but sadly, I cannot. Millions of Americans face this or will face this very problem in the near future. At the end of this article, you will find posts with more in-depth stats regarding pensions and the trouble on the horizon.

*NOTE: I go into much more detail in the posts mentioned at the end of this article but I’ll say this now: the vast majority of multi-employer pension plans are healthy and in good shape. There are some, however, that are unhealthy and close to insolvency (unable to pay benefits) and unfortunately, these plans are LARGE. Individuals who receive a retirement from those plans are likely going to experience DEEP cuts in the future. Although most plans are doing well, it only takes a small minority to really bring the negatives of defined benefit plans (pensions) to light. Thus, we have the point I made, no matter how much we may not like it.*

Defined Benefit Positives

Let’s shed a little light on the benefits of Defined Benefit Plans

Despite the negatives associated with defined benefit (pensions) plans, there are positives that cannot be ignored. Added together, they present a great case for them, as we’ll see.

The first benefit is a fairly obvious one: a steady amount of money for retirement for the rest of your life. Of course, this is dependent upon the health of the plan but as long as it remains solvent the checks keep coming. Dependable is in the house!

The second positive in the defined benefit (pensions) corner is the individual doesn’t have to do any work – it is the plan administrators who do. As far as you are concerned, it’s hands-off. For many people, that’s just the way they want it. After all, life is full of being busy – even if we aren’t really getting anything done.

A third positive in the camp is the risk isn’t yours – it’s the company/organization which endures the risk associated with investments. You could say by extension the retiree is affected, and you would be right. But day-to-day investment growth, the overall health of the plan isn’t on you to maintain – and that is a freeing thought, to be sure.

Let’s look into the Defined Contribution plans and see the differences.

Defined Contribution Negatives

The negatives of Defined Contribution Plans – what are they?

One of the negatives for the defined contribution (401k/Annuity fund) is that the burden to save is on you, the individual, vs the company or organization that provided the defined benefit (pensions). The risks associated with investment gains and/or losses are on you the individual. And of course, it’s on you to not only save but do so with a responsible and thoughtfully planned out retirement goal.

Personally, I don’t think this is all that negative given we are prone to wanting our freedoms – this is a dose of responsibility alongside it. Sure, when compared to a defined benefit (pensions) it pales in comparison but I’m of the mindset you can’t have too much for retirement and this is another vehicle (one which you have more control of, honestly).

Another negative of the defined contribution (401k/Annuity fund) is the money you accumulate doesn’t last forever – once it’s gone it’s gone. This makes planning and saving VERY important. You cannot be hands-off with this type of retirement plan. If you are, you may end up a pauper on the bread lines. A defined contribution (401k/Annuity fund) plan requires intentionality from you, the saver. You have to do your homework on tax treatment, amount of money to save, investments, etc.; It really is ALL on you.

Defined Contribution Positives

Let’s take a look at Defined Contribution positives

Now, even though I said that on the surface defined benefit (pensions) were better, that doesn’t mean defined contribution (401k/Annuity fund) plans don’t have positives. So, what are they?

First, YOU control the investments. Some consider this to be a burden but others see it as control – and that’s a positive. If you want to be conservative, aggressive, or a mix it’s your choice. There are parameters, of course, but overall it’s up to you.

Second, you control the contributions. Now, if you ask me if I want to save my own money or someone else’s for retirement I’ll say someone else’s – every time. But, let’s be real for a moment: whose responsibility is it to prepare for retirement? And, if you are a savvy retirement planner, you now have a vehicle that allows you to save possibly even more money than if you merely had a defined benefit (pensions).

The third positive of defined contribution (401k/Annuity fund) plans is the money is yours. Should the company you work for go bankrupt, go out of business, succumb to poor business practices, or other death-to-company events, the money in your defined contribution (401k/Annuity fund) is yours. This is not true with a defined benefit (pensions) plan as some have gone and more will become unable to pay out benefits.

Yet another in the positive column for defined contribution (401k/Annuity fund) plans is portability. You take your funds wherever you go and that’s a benefit for sure. With defined benefit (pensions) plans, you have to wait to become vested (eligible to draw from the plan) and if you leave you’re still vested and will still receive retirement funds (as long as the plan remains healthy) but nothing transfers. Again, we’re talking control.

*NOTE: multi-employer pension plans have portability built-in – see the articles below for more information.*

The last positive I can think of is this: if you are smart, a super saver, and start when you are young, you have the potential to grow that defined contribution (401k/Annuity fund) into a POWERHOUSE. You could find yourself in a situation where the balance is large enough for you to live off of the interest alone. You have effectively created your own pension, in a way. Time and compound interest are your greatest friends and if you utilized them to their max you could end up with essentially a privatized, personal pension. Now THAT is a good place to be in. Few see this manifest because it takes discipline and A LOT of hard work.

Where collective bargaining fits in

CBAs have great advantages

By now I imagine some are wondering if there are problems with having both types. Not at all is the answer. The more vehicles at your disposal the better your chances of having a better standard of living in retirement. If possible, having both provides you with diversified retirement accounts, and by all measures, diversification is definitely a bonus. So how does collective bargaining fit into the equation?

Collective bargaining is, by all rights, a diamond in the rough, and for good reason: they have, in my opinion, the BEST retirement game in town. Not only do they have a defined benefit (pensions) plan but almost all have a defined contribution (401k, Annuity fund) plan as well, but the defined contribution they have though is called an annuity fund. Click here to delve further into annuities – what they are and what they aren’t from a collective bargaining perspective. Sneak peek: Annuities offered under CBAs are NOT what many investment professionals think they are.

There are differences between the annuity funds money gurus know and the annuity funds covered under collective bargaining agreements. Be sure you don’t get them confused like many money managers do. It’s staggering what information ISN’T out there for the annuity funds skilled tradesmen have under collective bargaining agreements. Truth be told, that’s one of the reasons I began this website in the first place. Each collective bargaining agreement is different, which makes understanding the nuances all the more difficult. Even so, there are some similarities across the board that I attempted to address.

Despite the difficulties understanding the nuances, the combined forces of a defined benefit (pension) and a defined contribution (annuity fund in this case) deliver a wallop on retirement. Who argues having both are a bad thing, when the current climate has a large number of Americans with NO SAVINGS AT ALL?

Surely we can agree having the most you can get is a good thing. Now, there are many more benefits to a collective bargaining agreement but for this post, I’m keeping it focused on the defined benefit (pensions) plans and the defined contribution (401k/annuity fund) plans. There are differences between the two retirement plans; study and know them so you can plan for retirement accordingly.

*NOTE: Although I am an advocate of the collective bargaining retirement funds and think they are a force to be reckoned with, I STRONGLY advise everyone to save as much as they can for retirement – with every vehicle at their disposal. Everyone has the ability to open and save in an IRA, which is an additional $6,000 (2019) in savings. If you are married, that’s another IRA and another $6,000 you can save, bringing the yearly total to $12,000. I’ve never met a person who said they saved too much or regretted saving too much. The same can’t be said for those who didn’t – and by the time they realize they didn’t save enough there is a serious time crunch. Save like your retirement depended upon it – because it does. *

Conclusion

When we consider the pros and cons of the two retirement plans, defined benefit (pensions) and defined contribution (401k/annuity fund), we can see much more than just the differences. Some may only have one type available to them but that’s better than nothing at all. I maintain we should save as much as we can while we can, no matter what vehicle we have at our disposal. Knowing the different types of retirement plans helps us to focus and plan accordingly. We all would do well in saving as much as we can – while we can.