What Is a Defined Pension Plan?
Workplace pension plans come in two broad varieties: Defined benefit pensions and defined contribution pensions. Defined benefit plans are what we think of as "traditional pension plans." In a defined benefit pension plan, the worker receives a guaranteed payout--generally based on compensation in the last years of service--regardless of market performance. Defined contribution plans receive no such guarantees. Instead, workers contribute to the plan and direct their investments to get the best return possible.
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Applicable Law
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The most important law governing pension plans, whether defined benefit or defined contribution, is the Employee Retirement Income Security Act (ERISA) of 1974. One of the law's provisions imposes a fiduciary standard upon plan sponsors. This means the plan sponsor is obligated to run the plan solely in the interests of its participants. The plan sponsor is prohibited from self-dealing within the plan in any way. All decisions must be made in the best interests of the workers.
Pension Benefit Guaranty Corporation
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ERISA also provided for the Pension Benefit Guaranty Corporation (PBGC), a quasi-government entity that guarantees the promised payouts of defined benefit pension plans. If a pension plan becomes insolvent and cannot make promised payments to workers, the PBGC steps in and takes over the payment of promised benefits, up to a maximum amount. This protection does not apply to defined contribution plans, however.
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Defined Contribution Plans
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The chief difference between a defined benefit plan and a defined contribution plan is that the worker assumes the risk of poor investment performance in a defined contribution plan. The worker makes contributions to the plan--typically pre-tax contributions, with salary deferral. The employer may contribute to the plan as well. The worker then directs the investment of the proceeds in an effort to maximize eventual retirement income while minimizing risks. Examples of defined contribution plans include 401k plans, 403b plans, Simplified Employee Pension (SEP) plans, the Federal Thrift Savings Plan, and Savings Investment Match Plans for Employees (SIMPLE) IRA plans.
Issues and Controversies
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The overall trend over the last 20 years, as of 2011, has been for corporations to scale back on defined benefit plans in favor of defined contribution plans. The reason is that plan sponsors of defined benefit plans become less competitive when they have to pay pension benefits for a large number of retired workers. Their cost structure causes them to lose business to younger, leaner companies that lack this obligation. Some groups, such as the Pension Rights Center, have criticized 401k plans and individual retirement arrangements for weakening the pension system.
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