10.2 Defined Benefit vs. Defined Contribution
The shift from defined benefit pensions to defined contribution plans is a major theme in modern retirement planning. Series 7 questions focus on who bears the investment risk.
Key FINRA Exam Takeaways
- Defined Benefit Plan (Pension): Promises a specific payout formula at retirement based on salary and years of service. Investment risk is born by the EMPLOYER. Favors older, highly compensated employees.
- Defined Contribution Plan (401k, 403b, Profit-Sharing): Specifies annual contribution amount; payout depends on portfolio performance. Investment risk is born by the EMPLOYEE. Favors younger workers with long compounding horizons.
- Actuary required: Defined benefit plans require an annual actuarial calculation to ensure sufficient funding.
| Feature | Defined Benefit Plan | Defined Contribution Plan |
|---|---|---|
| Retirement Benefit | Fixed formula (e.g., 60% of average final 3 years salary) | Variable (Depends on portfolio market returns) |
| Who Bears Investment Risk? | EMPLOYER | EMPLOYEE |
| Actuary Required? | YES (Annual actuarial valuation required) | NO actuary needed |
| Favors Which Employee? | Older employees close to retirement | Younger employees with long horizons |
Knowledge Checkpoint • Section 10.2
A 58-year-old corporate executive earns $280,000 annually. The company wants to establish a qualified retirement plan that maximizes annual tax-deductible contributions for this executive. Which plan is MOST suitable?