A generation ago, it was common for retirees to live off their well-funded company pension plans. Although that situation is less common today, pension dollars are still a key piece of retirement income for those with an employer pension plan.

Not all pension plans are created – or distributed – equally, so it’s important to know the difference between a defined benefit plan and a defined contribution plan.

Defined benefit plan

In general, a defined benefit plan uses your salary and years with the company to calculate how much pension money you will receive at retirement. Your employer is responsible for making sure the plan can cover all staff pensions, so if there are shortfalls, the company – or, in certain plans, the company and employees – must increase their contributions.

With the defined benefit plan, your HR department can usually provide you with your pension estimate. Larger pension providers often let you calculate your estimate online.

Defined contribution plan

With a defined contribution plan, also called a money purchase plan, your employer regularly contributes a known amount of money, usually a set percentage of your earnings, to your pension. Some plans allow you to top that up with your own contributions.

With this type of plan, you are responsible for selecting the investments you hold, which means you are responsible for the returns that those investments earn. Because your contributions and market fluctuations affect your pension balance, it’s difficult to accurately predict how much pension income will be available to you at retirement.

Small employers usually prefer defined contribution plans because they limit how much the company is required to contribute and are relatively simple to administer and understand.

Here is an easy-to-reference chart that identifies the main differences between both types of plans: