Defined Contribution Plan (Definition, Example)

Defined Contribution Pension Plan Definition

A defined-contribution pension plan is a form of retirement plan where the employee or the employer and in some cases both of them make significant amount of contributions and that too on frequent basis with a motive to enable employees to save a decent amount of money for his retirement period and allow him to leave with utmost level of dignity in his or her retirement phase.

Explanation

Defined contribution pension plan can be regarded as a sort of a 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 having the need to depend on others for financial help.

How does it Work?

The total amount of retirement benefit to be received by an employee in a defined contribution plan is not pre-known. The amount of retirement benefit or the pension amount totally depends on the overall value of the contribution that is made by the employee and his or her employer as well as the returns that are supposed to be generated on their investment. The amount poured in the plan is contributed either by the employee or both by him/her and his/her 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 – This type of plan is only provided to individuals that are employed in public companies and businesses.
403(B) plan – This type of plan is only provided to individuals that are employed in non-profit corporations.
457 plans – This type of plan is only provided to individuals that are employed in non-profit business groups and as well as in the case of state employees and municipal employees.
529 plans – This type of plan is only provided for the purpose of funding a teenagers’ college education.
Thrift Savings Plan – This type of plan is only provided to individuals that are employed by the federal government.

How to Invest in a Defined Contribution Plan?

An employee can choose to voluntarily contribute a particular portion of his or her salary toward the defined contribution plan. The employee can derive the most of his plan by continuing to add to tax-deferred retirement savings plan for every month during the entire phase of employment, maximizing the amount that is contributed to the retirement savings plan, not spending these savings until the date of maturity, and taking professional advice with respect to where these funds can be invested for the purpose of deriving maximum benefits and generating higher level of returns.

Example of Defined Contribution Plan

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

Defined Contribution Plan vs Defined Benefit Plan

Defined benefit plans are professionally managed while defined contribution pension plans are not managed that way.
Defined contribution plan does not guarantee retirement income for the entire life received from the employer in the form of an annuity whereas the same is totally ensured in these plans.

Advantages

The advantages are discussed below-

Tax-deferred is the first and foremost benefit of participating in a defined contribution pension plan. This benefit enables the savings to grow faster and larger in comparison to the taxable accounts.
The automation of participant enrollment is another advantage of this plan since it mandates the employees to participate in the same and safeguard their retirement phase from financial contingencies.
It also offers various benefits like loan provisions, catch-up contributions, and automatic enhancement in contributions, and hardship withdrawals for employees who have attained the minimum age of fifty.

Disadvantages

It could be a pain for some participants that are not financially well off or are able to save money for making such contributions. Employees that lack knowledge pertaining to making an investment in bonds, stocks and other classes of assets might end up making investments in riskier or improper portfolios. These drawbacks of the plan are sufficient enough for receiving criticism from the employees who are not willing 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 limits that are prescribed by the plan. It lacks an adequate level of management. This means that this type of retirement plan is not professionally managed and this plan does not even ensure retirement income for the overall life that would be received from the employer in the form of an annuity.

Conclusion

Defined contribution plans are a type of retirement plans to safeguard the employees from financial contingencies that could be faced by him or her in the retirement age. 401 (K), 403 (B), 457 plans, 529 plans, The Thrift Savings Plan are some of its types. 401 (K) is regarded as one of the contributions of the most common type.