Defined Benefit Plan vs. Defined Contribution Plan
Employment-based pension plans pay retirement benefits to the employees of an organisation based on factors such as salary, amount of contribution, number of years worked in an organisation, etc. Such plans are primarily of two types – Defined Benefit Plan and Defined Contribution Plan. These are also considered non-insurance pension plans, as it is not possible to purchase them from an insurance company.
In both plans, a part of your salary gets deducted and deposited during your employment period. The amount is invested into various securities to generate returns.
The return on investment is distributed as an annuity or a lump-sum amount after the employee retires. However, defined benefit and defined contribution plans differ when it comes to how they work and how they benefit. Let’s discuss their differences in detail.
What is a Defined Benefit Plan?
A Defined Benefit Plan is an employment-based pension plan where the retirement benefit is predetermined. Hence, investing in such a plan can help an employee chalk out his/her financial goals and formulate a retirement plan accordingly.
You will receive the pension amount after retirement based on your salary history and the number of years of service. Additionally, the employer is responsible for investing the funds into various financial assets and distributing the returns to the employees after their retirement.
As a result, the employer bears maximum risk, as the returns on investment might not cover the benefit amount, due to an employee after retirement. On the other hand, the employees have very little control over the investments until they are eligible to receive the benefit.
Additionally, you can avail of two different payment options under this plan: annuity and lump-sum. In an annuity payment option, the retirement benefit is segregated and paid monthly to the employee after he/she retires. In a lump sum payment option, the entire amount is paid at once.
- Benefits of Defined Benefit Plan
Some of the advantages of investing in a Defined Benefit Plan are:
- Retirement security: Provides financial security to employees after retirement.
- Tax Benefits: Employers can enjoy tax benefits against the contributions made to the Defined Benefit Plans of employees as per section 80CCC of the IT Act.
- Spousal support: The spouse will be able to receive payouts even after the death of the contributor.
- Improves employee retention: Offering this pension plan to the employees can help to retain them for a longer period as employees can earn the most retirement benefits.
- Immune to market volatility: As the retirement benefit amount is pre-set, market fluctuations do not affect the value of the benefit. The employee will receive the predetermined amount post-retirement.
- Examples of Defined Benefit Plans
Some examples of Defined Benefit Plans are gratuity, leave encashment salary, retrenchment compensation, Voluntary Retirement Scheme (VRS), Guaranteed Savings Plan, Central Civil Services Pension and pension for Public Sector Bank Employees, etc.
What is a Defined Contribution Plan?
A Defined Contribution Plan is an employment-based pension plan where the employee is the primary contributor. Sometimes, employers also contribute to such plans but only up to a certain amount.
The employee will receive the pension amount after retirement based on their contribution and returns generated by the investment. Additionally, one can decide to invest in equity or debt assets based on his/her risk appetite. Some of the popular defined contribution plans include Employee Provident Fund (EPF) and National Pension System (NPS).
In an Employee Provident Fund (EPF), a part of your salary gets invested in an Employee Pension Scheme (EPS). Generally, you can contribute 12% of your salary to the EPF account, which your employer matches accordingly.
In the case of the National Pension System (NPS), you can invest till the age of 60, with a minimum annual contribution of ₹6000. There are two types of NPS accounts – Tier I and Tier II. It should be noted that the Tier I NPS account is a long-term plan, and the amount cannot be withdrawn until retirement.
Benefits of Defined Contribution Plan
Some of the advantages of investing in a Defined Contribution Plan are:
- Automatic savings option: When an employee invests in a defined contribution plan, a part of their salary gets deducted automatically on a regular basis.
- Tax benefits: Employees can enjoy tax benefits from investments made in a Defined Contribution Plan under section 80CCC of the IT Act.
- Higher contribution limits: Employees get an opportunity to contribute more because there’s no limit set on the amount of investment.
- Employer contribution: Some defined contribution plans require employers to match a part of the employee’s investment.
- Examples of Defined Contribution Plans
Some examples of a Defined Contribution Plan are Employee Provident Fund (EPF), Public Provident Fund (PPF), Voluntary Provident Fund (VPF), National Pension Scheme (NPS), Unit Linked Insurance Plans (ULIPs), and Employee Deposit Linked Insurance Plan.
Also Read: What is VPF – Voluntary Provident Fund?
What are the differences between a Defined Benefit Plan and a Defined Contribution Plan?
Although both defined benefit plans and defined contribution plans are reliable pension plans, there are a few differences between them that employees should know before making any investment decisions.
|Defined Benefit Plan||Defined Contribution Plan|
|Benefits are fixed based on certain calculations during the time of retirement.||Benefits are not fixed, as the returns depend on the performance of the underlying assets.|
|It is considered to be beneficial for employees.||It is considered to be beneficial for employers.|
|Participation in this policy is usually automatic.||Participation in this policy is often voluntary.|
|An employee does not have to worry about the management of the underlying investment portfolio.||The employee has to worry about the contribution and investment portfolio of these funds.|
|Investment is the liability of the employer.||Investment risk is borne by the employee.|
Should you invest in a Defined Benefit Plan or a Defined Contribution Plan?
In the case of a Defined Benefit Plan, employee contributions aren’t limited; however, the administration costs tend to be higher than a Defined Contribution Plan. You can contribute depending on your age, income level, and current salary. The retirement benefits are also pre-defined. Hence, these plans can be ideal for employees who wish to get a definitive idea about the return on their investments and are open to contributing more.
However, if you wish to invest a limited amount towards a retirement plan, you can consider investing in a defined contribution plan. The contributions are discretionary, unlike a defined benefit plan where you will be required to make an annual contribution. However, the administration charges may cost more, and the returns will depend on the performance of the underlying assets.
It is important to start your retirement planning early, irrespective of whether you choose to invest in a defined benefit plan or a defined contribution plan. Early planning will offer you more time to invest your funds as per market volatility and rate of return.
Make sure to choose a retirement plan as per your requirements. Start investing now to enjoy financial benefits during your retirement.
Frequently Asked Questions
Can you invest in a Defined Benefit Plan and a Defined Contribution Plan at the same time?
Yes, you can invest in a defined benefit plan and a defined contribution plan together at the same time. There are multiple hybrid employment-based pension plans offered by employers that combine the features of the two types of pension plans.
Why is a Defined Contribution Plan more popular among employers?
A defined contribution plan is more popular among employers as they are funded primarily by the employees. Employers do not have any obligation towards the fund’s performance, the plans require little work, and they are cost-effective. Furthermore, the employees also appreciate the option of making investment decisions on their own.
When can you withdraw from a Defined Benefit Plan?
Employees can generally withdraw their investments from a defined benefit plan after retirement. Certain defined benefit plans have a pre-set retirement age for the employee. However, many small plans allow the contributor to cash out and avail of the benefits as per their requirements.
When can you withdraw from a Defined Contribution Plan?
Withdrawal from a Defined Contribution Plan depends on your age and years of work experience. For NPS, in case of Superannuation- A Subscriber can claim 100% Withdrawal if the total accumulated corpus is less than or equal to Rs. 5 lakh at the time of Superannuation/attaining age of 60 years. In case of Pre-mature Exit- If total accumulated corpus is less than or equal to Rs. 2.5 lakh, the Subscriber can avail the option of complete Withdrawal. However, you can exit from NPS only after completion of 5 years. For EPS, If you have completed 10 years of service and attained 50 years of age, you can withdraw your pension early, before 58 years of age. However, in this case, you will receive a reduced pension only. The rate of pension is reduced by 4% for each year left till you attain 58 years of age.
Can I withdraw funds from my NPS fund but continue as a contributor?
Yes, you can withdraw funds from your NPS fund before the end of the tenure. However, this is possible if you have been a contributor to NPS for at least 3 years and the withdrawal amount is not exceeding 25% of the contributions. You can continue as a contributor after making this partial withdrawal.
However, note that the withdrawal is allowed for valid reasons like children’s education, marriage, medical emergencies, etc.