Defined Contribution v/s Defined Benefit

The two popular routes adopted by employers to provide retirement corpus to its employees is defined by the following ways: 

·         Defined Contribution Plan

·         Defined Benefit Plan

What is a Defined Contribution Plan?

A Defined Contribution Plan is where the employee contributes a set amount of money each pay period, and upon retirement the amount contributed and any interest or profits made on those contributions becomes available the employee. E.g. Provident Fund or 401(k)

In this type of plan, the risk lies with the employee. The contribution is fixed and in long run, the employee might not get the desired rate of return on his investment. Also if he lives longer, he might not even be able to survive the collected income. During the contribution phase, the entire amount is invested as per the pre- designed avenues. The amount on retirement is tax efficient.  

The employer is on the safer side with this kind of plan as the contribution is fixed and to be in parts during the service of the employee and not make delayed payments on retirement.   

What is a Defined Benefit Plan?

In a Defined Benefit plan an employee is guaranteed of a per-determined payment at the time of retirement based upon the tenure of his service with an employer prior to retirement. E.g. Pension or Gratuity.

In this type of plan, the risk lies with the employer. The payment on retirement depends on the length of service and last drawn salary. In order to qualify for the benefit employee needs to complete minimum years of service. The employer needs to make provision for the payment assuming the employee going to work for him till he retires. If the employee leaves immediately after qualifying for benefits, the employers needs to be ready to make lump sum payments. Although, the formula of benefit amount is pre-defined, in case if the funds fall short the employer needs to fill the gap.    

Globally companies are moving towards Defined Contribution Plans as it reduces the risk on employers to make provision for future retirement benefits.