Defining the Landscape: Defined Benefit vs. Defined Contribution
Before exploring specific options, it is essential to understand the two core categories of retirement plans that provide pension-like income: defined benefit and defined contribution. The key difference lies in who bears the investment risk—the employer or the employee.
Defined Benefit (DB) Plans
Often called a traditional pension, a defined benefit plan promises a specific monthly income in retirement. The payout is typically calculated using a formula based on an employee's salary history, age, and years of service. With these plans, the employer funds and manages the plan's investments, assuming all market risk. The financial security comes from the guaranteed lifetime payment, regardless of market performance. Because of the cost and risk to employers, these are now rare in the private sector but still common for many public sector workers.
Defined Contribution (DC) Plans
Defined contribution plans, such as a 401(k), 403(b), or 457(b), are more common today. With these plans, the benefit amount is not fixed. Instead, it depends on the total contributions made by the employee and, often, the employer (via a match) plus the investment performance over time. The employee is responsible for managing the investment choices and bears the market risk. When it comes time to retire, the employee takes distributions from their accumulated account balance.
Comparing Defined Benefit vs. Defined Contribution
| Feature | Defined Benefit (DB) | Defined Contribution (DC) |
|---|---|---|
| Benefit Amount | Predictable, guaranteed monthly payment based on a formula. | Variable, based on total contributions and investment performance. |
| Funding | Primarily employer-funded. | Funded by both employer (optional match) and employee. |
| Investment Risk | Borne by the employer. | Borne by the employee. |
| Portability | Often not fully portable; can be less generous if changing jobs. | Fully portable; can be rolled over to a new plan or IRA. |
| Payer | Employer or insurance provider pays the benefit. | Employee draws funds from their own account. |
A Closer Look at Employer-Sponsored Pensions
For seniors who worked for companies or organizations offering a pension, several specific types may apply.
Traditional Pensions
These are the classic defined benefit plans, where retirees receive a monthly annuity for life. The amount is determined by a formula considering years of service and salary history. This provides a reliable, steady income stream that retirees cannot outlive.
Cash Balance Plans
A type of defined benefit plan, a cash balance plan defines a promised benefit in terms of an account balance, which grows with annual “pay credits” and “interest credits”. Although it looks like a defined contribution plan to the employee, the employer still bears the investment risk and guarantees the account's growth. Upon retirement, the employee can take the benefit as an annuity or a lump sum.
Modern Retirement Plans: 401(k)s and 403(b)s
For many seniors, their “pension” is a defined contribution plan like a 401(k) from a private company or a 403(b) from a public school or non-profit. These are self-directed savings plans where the retirement income is the result of decades of personal and employer contributions and investment returns.
Government-Sponsored Retirement Income
For most Americans, the federal government is a key source of pension-like income.
Social Security Retirement Benefits
Social Security is a federal social insurance program funded by payroll taxes. It provides a basic level of retirement income to eligible workers. The monthly benefit is calculated based on an individual's highest 35 years of earnings, with the amount potentially increasing if you delay claiming benefits beyond your full retirement age.
Public Employee Retirement Systems (PERS)
Many state and local government employees, including teachers and firefighters, participate in state-sponsored pension systems. Some of these plans, such as the Federal Employees Retirement System (FERS), are hybrid models combining a basic benefit plan, Social Security, and a defined contribution plan (the Thrift Savings Plan).
VA Survivors Pension
Qualified low-income surviving spouses and unmarried dependent children of wartime veterans may be eligible for a tax-free Survivors Pension from the Department of Veterans Affairs. This benefit helps provide a monthly payment to those who meet specific income and net worth criteria.
Personal Pension Alternatives and Payouts
Beyond employer- and government-sponsored plans, seniors have other options.
Annuities
An annuity is a contract with an insurance company that promises a stream of income in exchange for a lump-sum payment or a series of payments. Seniors can use a portion of their retirement savings to purchase an annuity, effectively creating their own personal, guaranteed pension for life. Various types, such as immediate or deferred annuities, offer different features and payout structures.
The Payout Decision: Lump Sum vs. Annuity
For many defined benefit plans, retirees face a crucial choice when they leave their employer: take the benefit as a monthly annuity or a single lump-sum payment. Each option has unique implications:
- Lump-Sum Payout: Provides a large sum of cash upfront, offering flexibility and potential for further investment growth. However, it requires careful management to avoid outliving the funds.
- Annuity Payout: Provides a steady, predictable income stream for life, eliminating the risk of outliving your money. However, the payments may not keep pace with inflation unless specifically designed to do so.
This decision should consider your health, financial needs, and overall risk tolerance. For more detailed information on comparing these payout options, it is helpful to consult authoritative resources on the topic, such as the Financial Industry Regulatory Authority (FINRA) guide.
Conclusion: Making Informed Choices
For seniors, pension income can come from a variety of sources, each with different structures and benefits. The once-standard, employer-funded defined benefit plan has largely been replaced by self-directed defined contribution plans in the private sector. However, government programs like Social Security remain a universal pillar, and personalized annuities offer another avenue for creating guaranteed income. By understanding the distinctions between these options, retirees can make informed choices to secure a stable and comfortable financial future.
