Defined benefit pension plan vs defined contribution pension plan

What is the difference between a defined benefit pension plan and a defined contribution pension plan? How does the pension fund model affect how much money I receive as a pension?

There are major differences between these two pension models, and many people saving for retirement do not fully understand these.

1. Defined benefit plan:

A defined benefit plan is what would rightfully be called a pension fund. It guarantees a specific amount of money which you receive as a monthly or annual pension when you retire. Right from the start, you know exactly what pension you can expect to receive based on how long you expect to make contributions and how high your contributions will be.

Example: A defined benefit plan may guarantee that a person who earns CHF 5000 per month and contributes to the pension plan over a 40-year time frame will receive a pension equal to 80% of their CHF 5000 salary – or CHF 4000 francs monthly. No matter how the fund performs, the pension fund is obligated to pay out the agreed-upon pension after that 40-year period.

A defined benefit plan becomes more complicated if your income is less predictable. Should your income increase over time or if you change employers, you may find yourself having to make additional contributions. For example, a monthly pension equal to 80% of your salary is guaranteed and your salary increases from CHF 5000 to CHF 5500 per month, you may have to make up the 10% difference in contributions for the entire contribution period leading up to your raise.

2. Defined contribution plan:

A defined contribution pension plan differs in that only the contributions to be paid are clearly defined, but the pension which you can expect to receive upon retirement is not. The pension you receive depends on how much you have contributed to the scheme by the time you retire.

In Switzerland, legal stipulations dictate the pension you receive. This is specified as a percentage of your total pillar 2a assets. The pension fund is required to pay out the pension throughout your retired life. When used for pillar 2 assets, defined contribution plans in Switzerland are fairly secure in that you receive a guaranteed pension relevant to the contributions you have made.

This sets pillar 2 pension funds using the defined contribution model apart from private pension funds using that model in that bad pension fund performance will not generally lead to your receiving a lower pension.

Verdict:

A defined benefit plan offers more security than a defined contribution plan because your pension is guaranteed. However, defined contribution plans allow for greater flexibility and when used for pillar 2a assets in Switzerland, also offer a fair amount of security.