Defined Contribution Plan

Article byWallstreetmojo Team
Edited byAnkush Jain
Reviewed byDheeraj Vaidya, CFA, FRM

Defined Contribution Pension Plan Definition

A defined contribution pension plan is a form of retirement plan where the employee, the employer, or both make a significant amount of contributions frequently to enable employees to save a decent amount of money for their retirement period and leave with utmost dignity in their retirement phase.

Explanation

A defined contribution pension plan is a sort of retirement plan in which an employee contributes a decent amount of his salary, and his employer, too, makes an equal contribution. It enables an employee to save a decent amount of money for his retirement years, which means he can live with dignity in his retirement age without needing to depend on others for financial help.

Defined Contribution Plan

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How does it Work?

The total retirement benefit received by an employee in a defined contribution plan is not pre-known. The retirement benefit or pension amount depends on the overall value of the contribution made by the employee and their employer and the returns that are supposed to be generated on their investment. The amount poured into the plan is contributed by the employee or their employer. The total amount contributed along with the returns will be deemed as the pension amount or retirement benefit earned.

Types

Following are the types of defined contribution plans –

  • 401(K) plan – It is for individuals employed in public companies and businesses.
  • 403(B) plan – This is for individuals employed in non-profit corporations.
  • 457 plans – It is for individuals employed in non-profit business groups and the case of state and municipal employees.
  • 529 plans – This type of plan funds teenagers’ college education.
  • Thrift Savings Plan – This type of plan is for individuals the federal government employment.

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How to Invest in a Defined Contribution Plan?

Employees can voluntarily contribute a particular portion of their salary toward the defined contribution plan. The employee can derive the most of his plan by adding to a tax-deferred retirement savings plan for every month during the entire phase of employment, maximizing the amount contributed to the retirement savings plan, and not spending these savings until the date of maturity. Moreover, they take professional advice concerning where these funds can invest in deriving maximum benefits and generating higher returns.

Example of Defined Contribution Plan

Mr. A opted to open a defined contribution plan where he is contributing a portion of his salary on a pre-tax basis. Mr. A can choose as much as he wants to save in this plan, but he must not exceed the maximum prescribed. His employer, too, shall make a matching contribution to the plan. This plan invests the funds accumulated in a portfolio of securities. The level of risks highly depends on the choice and composition of the portfolio in which Mr. A feels most secure and comfortable. However, in most cases, employees like Mr. A might get to choose from numerous portfolio options. In addition, he can try and withdraw funds during his retirement age. If A wishes to withdraw his funds before retirement, he will have to bear penalties as the plan offers.

Defined Contribution Plan vs Defined Benefit Plan

  • One manages defined benefit plans professionally, while one manages defined contribution pension plans differently.
  • A defined contribution plan does not guarantee retirement income for the entire life received from the employer in the form of an annuity. In contrast, the same is ensured in these plans.

Advantages

The advantages are as below:

Disadvantages

It could be a pain for some participants who are not financially well off or can save money to make such contributions. In addition, employees who lack knowledge about investing in bonds, stocks, and other classes of assets might make investments in riskier or improper portfolios. However, these plan drawbacks are sufficient for criticism from employees unwilling to lose their hard-earned money.

Limits and Restrictions

An employee can choose to invest in defined contribution plans, but the same must not exceed the plan’s limits. It lacks an adequate level of management. It means that this type of retirement plan is not managed professionally, and this plan does not even ensure retirement income for the overall life that one would receive from the employer in the form of an annuity.

Conclusion

Defined contribution plans are a type of retirement plan to safeguard employees from financial contingencies they could face in retirement age. 401 (K), 403 (B), 457 plans, 529 plans, and the Thrift Savings Plan are some of their types. 401 (K) is one of the contributions of the most common type.

Recommended Articles

This article is a guide to the Defined Contribution Plan and its definition. Here, we discuss how a defined contribution pension plan works, its types, advantages, disadvantages, and limits. You may refer to the following articles to learn more about finance: –

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