There are two general types of retirement plans: the Defined Benefit Plan and Defined Contribution Plan.
Defined Benefit Plan
This type of plan promises that upon retirement the employee will receive a defined (known) monthly income for the duration of their lifetime. The yearly contributions necessary to provide the promised monthly benefit upon retirement are unknown, however, these contributions are dependent upon a number of variables, such as:
- the amount of the monthly benefit to be received upon retirement
- the number of years an employee has left until retirement
- the length of time benefits will be received after retirement
- the amount of income that can be earned from the accumulating yearly contributions
Defined Contribution Plan
This plan is one in which the contributions to the plan are known (defined); however, the amount of money to be distributed upon retirement is unknown. This amount of money will be dependent upon the manner in which the yearly contributions have been invested and how much they have grown in value over the years of employment.
For example, the employee and/or the employer contributes yearly into the plan a fixed percentage of the employee's earned income each year. The money contributed to the plan is used to purchase stock, bonds, mortgages, certificates of deposit, treasury notes, etc. The value of these investments and the interest generated as a result will be distributed to the employee in one lump sum upon retirement. Upon receiving this lump sum distribution, the employee usually purchases an annuity which provides him with a specific monthly income for life.