RETIREMENT & OTHER CONCEPTS · 6 MIN READ
Qualified Plans: Defined Benefit vs Defined Contribution
Every employer retirement plan question starts with one classification: is the plan defined benefit (DB) or defined contribution (DC)? A DB plan promises a specific retirement benefit determined by a formula — most commonly final-average compensation times years of credited service times a stated benefit percentage. The employer bears all investment and longevity risk, must fund the plan actuarially, and the promised benefit is insured by the PBGC up to statutory limits. A DC plan, by contrast, promises only an individual account: contributions plus investment results. The participant bears the investment risk, and whatever the account is worth at retirement is the benefit. Hybrid designs are heavily tested because they look like one type but are legally the other. A cash balance plan is legally a DB plan that shows each participant a hypothetical account receiving annual pay credits and interest credits at a rate stated in the plan document — the interest credit is a plan promise, so the employer still bears investment risk. A target benefit plan is the mirror image: it calculates contributions using DB-style actuarial assumptions aimed at a target benefit, but it is legally a DC plan (a form of money purchase plan) because the participant receives only the actual account balance — more if investments outperform, less if they underperform. Rounding out the DC family: a money purchase pension plan requires a fixed annual employer contribution percentage; a profit sharing plan permits discretionary employer contributions (which can be cross-tested or age-weighted in allocation); and an ESOP invests primarily in employer stock, with special diversification rights and the net unrealized appreciation (NUA) tax election at distribution.
Watch it instead: DB or DC: Who Eats the Investment Loss6:37 interactive video · pauses twice to check youKey rules
A DB plan promises a formula benefit; a DC plan promises only an account balance.
The classic DB formula is final-average pay x years of service x a benefit percentage. In a DC plan the benefit equals contributions plus investment earnings, whatever they turn out to be.
Why the exam cares: The exam tests who bears investment risk: the employer in DB plans, the participant in DC plans.
A cash balance plan is legally a defined benefit plan despite its account look.
Each participant has a hypothetical account credited with pay credits and interest credits at a rate the plan document guarantees, capped at a market rate under the Pension Protection Act.
Why the exam cares: Examiners love hybrids: candidates who classify by appearance rather than by who bears the risk pick the wrong answer.
A target benefit plan is a DC plan even though contributions are set actuarially.
Contributions are calculated to hit a target benefit, but the participant's actual benefit is just the account balance — there is no employer make-up if returns fall short, and no PBGC insurance.
Why the exam cares: This is the reverse trap of the cash balance plan and the two are routinely tested side by side.
Top-heavy plans (over 60% of benefits to key employees) owe minimums to non-key staff.
A key employee is an officer over an indexed pay threshold, a more-than-5% owner (any compensation), or a 1% owner earning over $150,000. Top-heavy DC plans must give non-key participants at least a 3% contribution plus accelerated vesting.
Why the exam cares: The exam asks which employee is automatically a key employee — the more-than-5% owner qualifies regardless of pay.
ESOP participants get diversification rights and the NUA election at distribution.
NUA lets a lump-sum distributee pay ordinary income tax only on the stock's cost basis, with the appreciation taxed as capital gain when the shares are later sold; the NUA election requires a qualifying lump-sum distribution.
Why the exam cares: NUA timing (lump-sum requirement) is a favorite advanced question in this section.
Numbers to memorize
- 60% — a plan is top-heavy when more than 60% of benefits or balances belong to key employees
- 3% — minimum employer contribution owed to non-key employees in a top-heavy DC plan
- $150,000 — compensation trigger making a 1% owner a key employee (not indexed)
- 5% — ownership level that makes an employee a key employee regardless of compensation
- 1.5% x $80,000 x 30 years = $36,000/year — textbook unit-credit DB formula example
Common traps
- Confusing a cash balance plan with a DC plan — remember it is legally DB: the interest credit is a plan promise and the employer bears investment risk.
- Confusing a target benefit plan with a DB plan — the actuarial math only sets the contribution; the participant gets the account balance, so it is a DC plan.
- Assuming a more-than-5% owner must also meet a compensation test to be a key employee — ownership alone is enough; only the 1% owner has the $150,000 pay condition.
- Assuming PBGC insures all retirement plans — it insures only defined benefit plans, so cash balance plans are covered but target benefit and other DC plans are not.
When you see any plan name, ask one question first — who eats an investment loss? Employer means DB; participant means DC — and answer from that classification.
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