Defined Benefit Contribution Plans: Classification of Pension Plans

Classification of Pension Plans

There are two main criterions to distinguish Pension Plans. The first criterion is the asset base for the liabilities for benefits promised to plan participants or employees:

1. Pension plans without a fund ( pay as you-go plans)
2. Pension plans with a fund (funded pension plans).

A pay as you go plan does not collect specific assets designated to create income needed to pay benefits. Alternatively, they depend on such future income generated by the plan sponsor to pay benefits. Such plans are endorsed and supported by the credit of the plan sponsor, the condition in such benefits are backed by the portfolio of capital assets.

In a pay-as-you-go plan type, participants depend on their employer for the security of their benefits. This condition overplayed step-ups the risk to plan participants. Funded pension plans avoid the possible pitfalls of pay-as-you-go plans. In the United States, qualified pension plans are funded. Nevertheless, pay-as-you-go plans are still a dominant form of pension plans between social insurance plans, such as OASDI in the United States.

The 2nd criterion for categorization of pension plans is the method of rectification of an imbalance between assets - liabilities. From that perspective, we make out differentiation between them:

1. Defined benefit plans
2. Defined contribution plans

If a defined contribution plan demonstrates imbalance, its future benefits are self-directing corrected. These definitions of defined benefit and defined contribution plans are nonstandard.

So, it is more common to define defined contribution plans as the plans for which only the shares are prescribed beforehand, while defined benefit plans are defined as plans for which benefits are prescribed in advance, and asset performance strikes effects the contribution levels required in to fund benefits.

A pay-as-you-go plan must be, it specifies a benefit which will be delivered to a participant aside from any fund so it shows a permanent imbalance. The levels of plan liabilities and contributions needed are established by an actuary.

Private defined benefit plans are accustomed in the US and Canada, but not in other countries. In these two countries, defined benefit plans must be funded. Private defined contributions plans in the United States and Canada developed rapidly beginning in the late 1970s. In a defined contribution plan, investment risk is absorbed by plan participants, and the only obligation of the employer is the contribution itself.

In a defined contribution plan, the employer constructs steady contribution to an individual account of a given employee. This investment risk shifting to the employees. This condition is often considered to be the main explanation for the seminal shift from defined benefit to defined contribution plans in the US.

If an employee terminates employment from an employer offering a defined benefit plan, such employee will typically receive pension benefit upon retirement based on a relatively shortened period of service and on the last wages with the said employer. Defined contribution plans, on the other hand, offer relatively easy transfer opportunities.

Both defined benefit plans and defined contribution plans can be financed solely by the employer, solely by the employee, or jointly by both parties. Contributory defined contribution plans are fairly common in the United States and Canada. In the United States it is fairly common for defined benefit pension plan to hold a balanced portfolio of approximately 60% stocks and 40% bonds.

It is quite common for plan participants in defined contribution plans to choose their own asset allocation. When ERISA was passed, assets of defined benefit plans amounted to 75% of all pension plan assets. Over 75% of new contributions flow into defined contribution plans. In such circumstance employers no longer start new defined benefit plans.

Requirement of actuarial valuation for defined benefit plans is not to be ignored here, as it increases costs substantially. In the face of the shift away from defined benefit plans, their proponents have worked to create new alternative designs, which may help stem the tide of the escape to defined contribution plans

Target benefit plans are planned as a hybrid between defined benefit plans and defined contribution plans; they are officially qualified as defined contribution plans, but their funding is based on projected retirement benefits. The second new alternative design is the cash balance plan. In a cash balance plan, a worker has exactly the same benefits and rights to them, as in a defined benefit plan.