There are two types of retirement income plans, which are classified as defined contribution plans and defined benefit plans, depending on how the benefits are determined.
Defined benefit plans
Defined benefit plans are recognized to be the most common type of retirement income plan in the United States. A defined benefit plan offers benefits from a trustworthy intermediary with the use of a specialized formula set forth by a plan sponsor. The plan has gained high prominence for benefits which will be paid post retirement. The defined benefit is known for encompassing pension plans that are not considered to be defined contribution, and thus they do not possess individual accounts.
Most of the pension plans which are offered by Government agencies or large agencies are known as FAP, or final average pay plans, via which the monthly benefit will be equivalent to the product of the number of years, the salary of the member at the time of retirement, and a factor called the accrual rate.
Defined contribution plans
In accordance with internal revenue code section 414, defined contribution plan is a well-renowned retirement income plan. It is considered to be an employer-sponsored plan along with individual accounts for every participant. The benefit of these plans is attributed solely to contributions which are made into individual accounts as well as investment gains on the funds, expense charges and reduce losses. These plans have gained high prominence in recent years. They are recognized to be the dominant form of plan in private sector. In these plans, the participants are known for choosing the kind of investment in which the funds of retirement income plan will be allocated.
This type of plan is declining at a steady rate in the United States. More employees are seeing pension funding as a financial risk which can be avoided by freezing plans and offering defined contribution plans in lieu of that. Defined contribution plans include 401(k), Individual Retirement Account (IRA) and profit sharing plans.