Through a profit-sharing plan, or deferred profit-sharing plan (DPSP), an organization gives its employees a share of its profits as reported in the company’s quarterly or annual earnings report. The plan is one way a business gives a sense of ownership in the company to its employees.
In the case of a profit-sharing plan, the employee is but a recipient. A company’s leadership team decides the dollar amount it will contribute to the plan and the business is the sole contributor to the plan.
In contrast, a pension plan is one of the types of retirement plans by which an employer makes contributions that are set aside for the future benefit of its employees. A plan administrator invests the funds on behalf of the employees to generate earnings that will provide an income stream for the workers upon their retirement. Understanding the differences between a profit-sharing vs. pension plan can help you make decisions for your retirement years.
Read More: What Is a Pension Plan?
Understanding the Profit-Sharing Plan
A profit-sharing plan has two distinguishing characteristics: The plan gives a business the option to make contributions to the plan on a quarterly or annual basis, meaning the contributions aren't mandatory – and the employer alone contributes to the plan. In these ways, the profit-sharing plan differs from a 401(k) and other types of retirement plans.
While the company alone decides the amount of cash it will allocate to each employee for a certain financial reporting period, the company must establish a set formula for the profit allocation. The allocations of company profits reflect a primary intent of the plan, which is to share a portion of its profits with employees to strengthen their commitment to the business.
One method a company may use to share its profits is the comp-to-comp method. With this approach, an employee's total, annual compensation is calculated. Next, the company divides that figure by the total compensation paid to all employees to determine the percentage the employee will receive of all the profits to be shared.
Understanding the Pension Plan
A pension plan requires that plan contributions be made by the employer, the employee and often both to an investment portfolio that an investment professional manages. The employer, which is the plan's sponsor, promises to make certain monthly payments to retired employees for life. The amount of this benefit is based on multiple criteria including the amount contributed and the number of years the retiree worked for the company.
The pension plan may be a defined-benefit plan or a defined-contribution plan.
The Defined-Benefit Plan
A defined-benefit plan (DBP) is administered by a financial intermediary and managed by professional fund managers on behalf of a company and its employees. The plan requires employers to guarantee the amount of the benefit that employees will receive at retirement regardless of the actual market performance of the plan’s underlying pool of investments. Typically, formulas used to calculate the payment amounts include employee earnings and years of service.
Employers that institute DBPs are liable for pension payments to their retirees in amounts stipulated by the defined-benefit plan rules. This means that if the plan’s assets are insufficient to pay the plan benefits, the company must pay the difference between the benefits owed and the available assets. If a company lacks the money to pay former employees amounts owed to them, the Pension Benefit Guaranty Corporation (PBGC) might pay a portion of the monthly payments.
Read More: Advantages and Disadvantages of Pensions
The Defined-Contribution Plan
Those employers that provide defined-contribution plans match their plan contributions, to some degree, to those of their workers. The actual benefit that any employee receives depends on the market performance and long-term management of the plan’s assets. This approach reflects the fact that the employer’s liability regarding the plan ends when its contribution is paid.
The plan’s cost is much less than that of a traditional pension, such as the 401(k) and 403(b,) which are defined-benefit plans, for which a company guarantees their employees' retirement benefits.
- U.S. Department of Labor: Types of Retirement Plans
- Internal Revenue Service: 2020 Publication 575
- Pension Benefit Guaranty Corporation: PBGC Guarantee Limit for Single-Employer Plans Increases for 2019
- U.S. Department of Labor: What You Should Know About Your Retirement Plan
- Internal Revenue Service: Choosing a Retirement Plan: Profit-Sharing Plan
Billie Nordmeyer is an IT consultant of 25 years standing. As a senior technical consultant for SAP America and Deloitte Touche DRT Systems, a business analyst, senior staff, and independent consultant, Billie has worked across the retail, oil and gas, pharmaceutical, aeronautics and banking industries. Billie holds a BSBA accounting, MBA finance, MA international management as well as the Business Analyst and Software Project Management certificates from the Cockrell School of Engineering at the University of Texas at Austin.