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Signed benefit plan

in this video we're going to talk about the difference between a defined benefit in a defined contribution pension plan and the differences as follows with a defined benefit plan basically the employer is promising a series of annuity payments to the employee for the rest of the employee's life after the employee retires so these annuity payments can be calculated in an infinite number of ways but I'll just give you one example so let's say that the employer says look for every year that you work for the company and let's say that the employee works 25 years at the company so for every year of service that you give to this company you can multiply that by two percent and then take that times the highest salary that you ever have when you're working at this company and let's say that that's a hundred thousand dollars right so let this is just hypothetical for an employee they work for this company twenty five years and their max salary that they ever made was a hundred thousand they multiply that by two percent and that's going to yield fifty thousand dollars so what does that mean that means that when this employee retires there will be an annuity payment an annuity payment from the the company to the employee of 50 thousand dollars a year for the rest of the employee's life now the responsibility is with the employer to make sure that there's enough money set aside to be able to make these payments to the employee right you'll hear about an underfunded pension plan that means that the employer hasn't set aside enough money to be able to make these payments to its employees okay so now there's all the risk with a defined benefit pension plan is basically with the employer right because the employee doesn't have to set aside any money to get this 50 thousand right the employee could not save anything at all and just say hey look I have this defined benefit pension plan to look forward to right and historically in the United States a lot of manufacturing companies and stuff throughout the twentieth century offer defined benefit pension plans and they actually used to be the most popular type of pension plan but now over time it's actually become more popular for firms to offer define contribution pension plan because it's a lot cheaper for the employer and a lot less risk and basically with a defined contribution pension plan the employer is not promising a series of annuity payments now they're just a promising to make contributions to the employees plan so they're promising to make contributions so one type of defined contribution plan is called a 401k so you might have heard of a 401k that's not the only type of defined contribution plan but basically with a 401k the way it works is that the employee has to make contributions to his or or own plan right so it might work as follows and it depends again on the company but let's just say that one way of doing is the employee contributes let's say $2000 in a given period let's say that this year they put in 2002 their plan right and this plan would be invested in like mutual funds or something like that right it's not like you're giving it to your employer right so it's going to be invested but you put 2,000 in this plan or the employee puts 2,000 and planless they put here employee and then the employer can match that right there'll be some kind of agreement like obviously when you get hired you'll have an agreement and let's just say that there's a 50% match and then that match might be like let's say up until the first up until the first 3,000 annually okay right some lot of times a firm will put a limit right so if you put in a hundred thousand they're not going to match you you know all the way up to 100 thousand they'll say look for the first three thousand will match you now if it's a hundred percent match then you put in two grand the employer gives you two grand but here in this example let's say it's a fifty percent match so then we have we'd have a thousand being put into the employees plan from the employer right so the employer is putting in a thousand dollars so then there would be three thousand total in the employees plan now you might be immediately noticing that all the risk here so if we think about risk so the risk with the defined contribution is on the employee because if the employee doesn't make enough contributions then the employer contributes nothing right and even if the employee does make contributions there's no guaranteed annuity payment where you say oh look when you retire you'll get $50,000 a year all the burden of saving is on the employee and the employers just making contributions occasionally now with the defined benefit plan most of the risk is with the employer now there are a few caveats to that right it's a little more complex than this but basically one major benefit of a defined contribution plan is it's portable it's portable and what I mean by saying portable is that a lot of people change jobs right so they change jobs actually quite frequently you might change jobs five to ten times during a career and you can take a 401k plan with you right and what I mean by that is if you have this three thousand dollars in your plan and then you go to a different company you can still keep this it's not like oh I lost that but if you let's say a company like has a defined benefit plan it might be something where hey look if you only worked here five years you're not eligible for the defined benefit plan or eligible to retire from that company maybe you get nothing or you know any of these assets they can't be pooled together let's say you have a defined contribution plan at your next employer whatever assets you have or anything that you've built up in this defined benefit any of that isn't going to be able to be mixed with a defined contribution you know basically probably you will get nothing if you have a defined benefit plan you work a few years and you leave but the defined contribution plan you could take those assets with you because remember this $3,000 is not that's not that the firm has that money that's your money and they've put money into your account that's what the matches they're matching your contribution to your own account right this is some some mutual fund account or something like that as you go to your next firm you know you just call up the mutual Oh fun and explain the hey I've gone to a new company and you can actually have the funds transferred and your new funds that you gave to your new employer it go right into this fund right and so so that's a real benefit is portability with the defined contribution plans which offsets some of the risk obviously from the employee now they have to bear all the risk but another thing is that with a defined benefit plan one disadvantage is if the company were to go bankrupt now the government at least in the United States offers some insurance protection and I won't go into that but you're not completely out of luck if your firm goes bankrupt but in a lot of cases Airlines and so forth have gotten rid of their pension plans in bankruptcy or in other transactions they be able to get rid of some of these pension obligations and so sometimes the employee will either get nothing or if there's some kind of insurance or protection from the government that might get something but it's less than what they were expecting right they're not going to get that full fifty thousand they were counting on so there's a lot of so even though the employer has all the burden of the saving this money to make sure there's able to make these annuity payments to the employee there's still the risk to the employee of hey I've got everything tied up with this one firm with this one employer it's not like my money is in a mutual fund or something the employer is managing the funds and they might have invested in mutual funds but they might have invested in their own stock or they might have done any number of things and if they were to go bankrupt you know I could lose everything or not get as much as I had hoped for and so the accounting for defined benefit is actually a lot more complex the defined contribution and that's something we'll talk about in the