Defined Benefit Vs. Defined Contribution Plan: Key Differences

For long, pension has been taking care of post-retirement needs of a large section of retirees. Defined benefit plan and defined contribution plan are two ways to arrive at this amount. This article aims to bring out the difference between the two and their associated benefits.

A defined benefit plan is a retirement plan where you know the pension amount of retirement benefit beforehand. In a defined benefit plan, the pension amount is calculated by taking into account your salary history and the number of years into service.In a defined benefit plan, you are assured of the pension amount irrespective of the returns generated by the pension fund. As you know the amount beforehand, you can formulate a budget accordingly. In India, public sector bank pension and central civil services pension are examples of defined benefit pension plans.As the amount of pension to be received is known beforehand in a defined pension benefit, it gives you the flexibility to chalk out your finances and plan for goals accordingly. However, of late, there has been a shift from defined benefit plans to defined contribution plans.

Contrary to a defined benefit plan, in a defined contribution plan, the pension amount is not known beforehand. Here, the pension amount depends on your contribution along with the returns generated by your investment. In this, a fixed amount is contributed by you and your employer over a period of time, which is invested in funds on varying degrees of risk including, equity and debt.In a defined contribution plan, you have the liberty to take your decision about the asset allocation. If you are aggressive, you can opt for equities. On the other hand, if market volatility makes you jittery, you can opt for debt funds. Additionally, you can also opt for a mix of equities and debt to get the best of both worlds.The National Pension System is an example of a defined contribution plan. It offers two choices for investments – active choice and lifestyle funds. The former gives you a chance to decide you own asset mix, while in the latter, the mix changes as you grow older.One of the biggest advantages of a defined contribution plan is that it allows you to be aggressive and avail a high pension amount and counter the effects of inflation, in the process. The final word Irrespective of whether you choose a defined benefit plan or a defined contribution plan, it’s essential to start retirement planning as soon as possible. Early planning will give more time for your money to grow and gain from the power of compounding in the long run.

The information contained herein is generic in nature and is meant for educational purposes only. Nothing here is to be construed as an investment or financial or taxation advice nor to be considered as an invitation or solicitation or advertisement for any financial product. Readers are advised to exercise discretion and should seek independent professional advice prior to making any investment decision in relation to any financial product. Aditya Birla Capital Group is not liable for any decision arising out of the use of this information.