A Defined-Contribution Plan is a retirement plan in which the contributions are predefined, typically by the employer, employee, or both. However, the future benefits that participants receive depend on the investment performance of the plan. Unlike defined-benefit plans, where the retirement benefits are guaranteed, a defined-contribution plan places the investment risk on the employees.
Characteristics of Defined-Contribution Plans
Predefined Contributions
The contributions to the plan are specified and can be made by the employer, the employee, or both. These contributions are usually made on a regular basis, such as monthly or annually.
Investment Performance
The final benefits received during retirement depend on the value of the investments within the plan. This can include stocks, bonds, mutual funds, and other types of investments.
Employee Risk
The risk associated with investment performance is borne by the employee. Therefore, the retirement benefits can fluctuate based on market conditions.
Portability
Defined-contribution plans are often portable, meaning employees can take their plan with them when they change jobs. Examples include 401(k) plans, 403(b) plans, and certain Individual Retirement Accounts (IRAs).
Types of Defined-Contribution Plans
401(k) Plans
A 401(k) plan is a common type of defined-contribution plan offered by employers in the United States. Employees can contribute a portion of their wages, often with employer matching contributions.
403(b) Plans
Similar to a 401(k), a 403(b) plan is available to employees of public schools and certain tax-exempt organizations.
IRAs (Individual Retirement Accounts)
An IRA is a retirement savings account that an individual can establish independently. Contributions to traditional IRAs may be tax-deductible, and the investment grows tax-deferred.
Profit-Sharing Plans
In this type, employers contribute a portion of their profits to employees’ retirement accounts. The contributions can vary each year depending on the company’s profitability.
Special Considerations
Contribution Limits
Both the IRS and plan administrators impose annual contribution limits on these plans, which are subject to change and typically indexed for inflation.
Vesting Schedules
Some employer contributions may be subject to vesting schedules, determining when the employee gains full ownership of the funds.
Tax Benefits
Contributions to defined-contribution plans often come with tax advantages, such as tax-deferred growth or tax-free withdrawals in retirement, depending on the plan type.
Examples of Defined-Contribution Plans
Example 1
An employee opts into a 401(k) plan, contributing 5% of their salary, while the employer matches 3%. Over the years, the investment grows, relying heavily on the performance of the stock market. When the employee retires, the accumulated value provides the retirement income.
Example 2
A non-profit employee contributes to a 403(b) plan, investing in various mutual funds. The employer does not provide matching contributions. The employee periodically reviews and adjusts the investments to reflect market conditions and retirement goals.
Historical Context
The defined-contribution plan concept gained widespread popularity in the late 20th century as employers sought cost-effective alternatives to defined-benefit plans. The Employee Retirement Income Security Act (ERISA) of 1974 was a significant legislative milestone that regulated these plans, improving their security and reliability.
Applicability
Employees
Defined-contribution plans are suitable for employees seeking to control their retirement savings and willing to bear investment risks.
Employers
Employers prefer defined-contribution plans due to predictability in their financial obligations and the ability to offer competitive retirement benefits to attract and retain talent.
Comparisons with Defined-Benefit Plans
Defined-Benefit Plans
- Coverage: Employer guarantees a specific retirement benefit.
- Risk: Employer bears the investment risk.
- Certainty: Fixed retirement income.
Defined-Contribution Plans
- Coverage: Contributions are predefined.
- Risk: Employee bears the investment risk.
- Certainty: Variable retirement income based on investment performance.
Related Terms
- Vesting: The process by which an employee earns the right to keep employer-contributed funds in a retirement plan, typically after completing a specific duration of service.
- Matching Contributions: Employer contributions that match employee contributions to a retirement plan, often up to a certain percentage.
- Tax-Deferred Growth: Investment earnings such as interest, dividends, or capital gains accumulate tax-free until the investor withdraws them, typically during retirement.
FAQs
Q1: What investment options are available in a defined-contribution plan?
Q2: Can I change my contributions to a defined-contribution plan?
Q3: What happens if I change jobs?
Q4: Are there withdrawal penalties?
References
- Employee Retirement Income Security Act (ERISA) of 1974
- Internal Revenue Service (IRS) - 401(k) Contribution Limits
- U.S. Department of Labor - Types of Retirement Plans
- Investopedia - Defined Contribution Plan
- AARP - Defined-Contribution vs. Defined-Benefit Plans
Summary
In conclusion, Defined-Contribution Plans provide a flexible and modern approach to retirement savings, favoring a structure where contributions are predetermined, but benefits vary based on investment performance. While they transfer investment risk to employees, they also offer significant investment control and tax advantages. Employers and employees alike prefer these plans for their predictability and portability features, making them a cornerstone of contemporary retirement planning.
