When we talk about retirement, it's not just how much you save, but how you save it. But the different types of retirement accounts can be confusing to navigate. One of the first retirement choices we make is whether we’ll take part in a defined benefit or defined contribution retirement plan.
Olivia S. Mitchell is a professor at the University of Pennsylvania’s Wharton School of Business, and studies retirement.
“A defined contribution plan is one where the company defines the contribution he's going to make. That is 6 percent or 3 percent of your salary gets put into an investment fund,” Mitchell says. “It builds up, hopefully a lot, over time. And then at retirement you get what you get, whatever the investments have earned.”
A defined benefit plan gives you a fixed amount at retirement instead. “The employer specifies what you will get as an income stream [in retirement] ... usually as a percentage of your salary,” Mitchell says.
Is one better than the other? It depends on who you ask. “It used to be the case that people thought defined benefit was the beginning and end of all pensions,” Mitchell says. “However, defined benefit plans have suffered, especially in the most recent global crisis. Many of them are seriously underfunded.” Mitchell adds that defined contribution plans can be more flexible, since it allows people to move money into new accounts if they leave a workplace.
A guide to U.S. retirement accounts Learn more about what kind of plans are out there and which is best for you. Plus, browse our other resources to help you reach your retirement goals.
Either way, it’s important to save as much as you can. According to Mitchell, if you’re planning to retire in your early 60s, you might need to save about 30 to 40 percent of your salary to be adequately prepared. “I tried convincing my two daughters who are in their 20s, that they should save 40 percent of their salary when they got their first jobs, and I didn't get very far,” says Mitchell. “I think I got them to 20 percent. But the point is, the earlier you start saving, than the more time you have for that saving to compound. It’s absolutely critical.”
Even if you aren’t able to save that much money before retiring, there are other options like starting a business or moving into a part-time position once you get older. And working later comes with some health benefits, too, according to Mitchell. “We know that in countries where people retire very early, they are also in very poor health. There’s a feedback effect between continuing to work longer and staying mentally and physically healthy. So it's not all gloom and doom.”