Both defined benefit and defined contribution plans will help you save for a secure retirement – but what are the differences between the two? Depending on where you work, your employer may offer you a choice between them, so it is important to choose the one that is best for you. If you are a Colorado PERA member and work in the State division, for instance, you will likely have the choice between the DB and DC plan. (It is a one-time choice, so choose wisely!)
Here's a little more information to help you decipher between the two.
What's a Defined Benefit Plan?
With a DB plan, your employer (or plan sponsor) will provide you with a specified monthly benefit that is calculated based on a predetermined formula. The formula is typically a combination of your salary history, your years of service, and your age at retirement.
It is called a “defined benefit” because the benefit formula is known in advance and you can plan your retirement based on the formula offered by your employer. The most common type of formula takes an average of your highest years of pay (generally your last years of employment) and multiplies that by your years of service and a specified multiplier. For example, your benefit formula might look like this: Highest Average Pay x Years of Service x 2.5% = Benefit. So if your highest average pay (monthly) was $5,000 and you had worked for 20 years, you would get a monthly benefit of $2,500 in retirement. This is the formula used in the PERA DB plan.
Other Choices to Consider
DB plans offer lifetime retirement benefits and often also allow you to choose an option that will continue to pay a lifetime benefit to a person (such as your spouse) upon your death.
Under the PERA DB plan you have three choices at retirement:
1) A lifetime benefit to you only
2) A lifetime benefit to you, and then once you die, that same benefit to your cobeneficiary for his/her lifetime
3) A lifetime benefit to you, and then once you die, half of that benefit to your cobeneficiary for his/her lifetime
A DB Plan for the 21st Century
With a DB plan, you and your employer each pay a specified percentage of pay into the plan throughout your employment, and the plan takes on the risk of the investment returns. In other words, you will receive your formula benefit and it is up to the plan to ensure that the investment earnings are sufficient to fund the benefits. Many DB plans offer cost of living adjustments during retirement for inflation protection. DB plans are good for people who would rather not manage their own investments.
The Colorado PERA DB plan is what is known as a “hybrid DB plan,” meaning that it contains elements of both defined benefit and defined contribution plans. PERA’s plan has been a hybrid plan for decades. One of the best hybrid features in the PERA plan is the fact that all of your member contributions go into your own member account, where they build guaranteed interest (currently 3 percent per year). If you leave PERA employment, your member account is portable – meaning you can either leave it at PERA or take it with you via a rollover into another qualified retirement plan (it will remain tax-deferred) or via a lump-sum distribution to you (you’ll pay tax).
Portability is great because it means that you can continue to build on your retirement account no matter where you end up. Depending on whether you meet certain requirements, you may also be eligible for a 50 or 100 percent match on your member account when you leave. One other important feature of the PERA DB plan is that you are eligible for a monthly benefit for life once you reach age 65 – some DB plans require you to have a minimum amount of years of service before you are eligible for a lifetime benefit. Under the PERA plan, all you need to do is reach age 65 to be eligible for a lifetime benefit.
What's a Defined Contribution Plan?
Unlike a DB plan, a DC plan does not offer a fixed benefit at retirement. Rather, the amount you have available to fund your retirement is entirely dependent on the amount that you and your employer have contributed to your account, and the investment earnings (or losses) that have occurred on those contributions. The amount you will have in retirement may be difficult to determine given that the amount depends on the success of your investment decisions, when you begin withdrawals, and your life expectancy. When the account is depleted, no further benefits are payable.
DC plans are often attractive to individuals who wish to manage their own investments. The most commonly known DC plan is a 401(k) plan. The plan will offer you an investment line-up, and it is up to you to decide which types of investments you would like your money in. It is important to examine your choices from time to time, and many investment professionals recommend that you begin to transition to more conservative investments as you progress in your career and get near retirement. Another important consideration is what fees you will be charged by the various investment options, as high fees can significantly cut into your investment earnings over time. It is a good idea to pay attention to the fees when you are choosing your investments.
Choosing the Right Plan
So how do you choose which plan is right for you? If you like to manage your own investments, then the DC plan might be the right plan for you. You should consider whether you have the time and knowledge to appropriately invest for your retirement security. If you would rather have a plan that offers a set benefit at retirement (for your entire life) and does not require you to make any investment decisions, then the DB plan might be the right choice. When you are looking at the differences, be sure to examine how long you are required to participate in the plan before you are vested in your contributions and your employer contributions.