The first step to understanding your retirement benefits is to find out what kind of retirement plan your employer has. There are two major types of plans, defined benefit and defined contribution. Keep in mind that your employer may have more than one type of plan, and may have different participation requirements for each.
A defined benefit plan, funded by the employer, promises you a specific monthly benefit at retirement. The plan may state this promised benefit as an exact dollar amount, such as $100 per month at retirement. Or, more often, it may calculate your benefit through a formula that includes factors such as your salary, your age, and the number of years you worked at the company. For example, your pension benefit might be equal to 1 percent of your average salary for the last 5 years of employment times your total years of service.
A defined contribution plan, on the other hand, does not promise you a specific benefit amount at retirement. Instead, you and/or your employer contribute money to your individual account in the plan. In many cases, you are responsible for choosing how these contributions are invested, and deciding how much to contribute from your paycheck through pretax deductions. Your employer may add to your account, in some cases by matching a certain percentage of your contributions. The value of your account depends on how much is contributed and how well the investments perform. At retirement, you receive the balance in your account, reflecting the contributions, investment gains or losses, and any fees charged against your account. The 401(k) plan is a popular type of defined contribution plan, and there are three types of 401(k) plans: traditional, SIMPLE 401(k), and Safe Harbor 401(k) plans. The SIMPLE-IRA plan, SEP, employee stock ownership plan (ESOP), and profit-sharing plan are other examples of defined contribution plans.
Note
1. Employers can choose whether to offer a retirement plan to employees; Federal law does not require employers to offer or to continue to offer a plan.
2. The Pension Benefit Guaranty Corporation (PBGC) guarantees payment of certain retirement benefits for participants in most private defined benefit plans if the plan is terminated without enough money to pay all of the promised benefits. The government does not guarantee benefit payments for defined contribution plans.
3. Some hybrid plans – such as cash balance plans – contain features of both types of plans described above. See the Glossary for information on this type of plan.
Source: U.S. Department of Labor