Defined contribution plan
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A defined contribution plan is a type of retirement plan in which the employer, employee or both make contributions on a regular basis. Individual accounts are set up for participants and benefits are based on the amounts credited to these accounts (through employer contributions and, if applicable, employee contributions) plus any investment earnings on the money in the account. Only employer contributions to the account are guaranteed, not the future benefits. In defined contribution plans, future benefits fluctuate on the basis of investment earnings. The most common type of defined contribution plan is a savings and thrift plan. Under this type of plan, the employee contributes a predetermined portion of his or her earnings (usually pretax) to an individual account, all or part of which is matched by the employer. In the United States, specifies a defined contribution plan as a plan which provides for an individual account for each participant and for benefits based solely on the amount contributed to the participant’s account, and any income, expenses, gains and losses, and any forfeitures of accounts of other participants which may be allocated to such participant’s account.
In a defined contribution plan, fixed contributions are paid into an individual account by employers and employees. The contributions are then invested, for example in the stock market and the returns on the investment (which may be positive or negative) are credited to the individual's account. On retirement, the member's account is used to provide retirement benefits, sometimes through the purchase of an annuity which then provides a regular income. Defined contribution plans have become widespread all over the world in recent years and are now the dominant form of plan in the private sector in many countries. For example, the number of defined contribution plans in the US has been steadily increasing, as more and more employers see pension contributions as a large expense avoidable by disbanding the defined benefit plan and instead offering a defined contribution plan.
Money contributed can either be from employee salary deferral or from employer contributions. The portability of defined contribution pensions is legally no different from the portability of defined benefit plans. However, because of the cost of administration and ease of determining the plan sponsor's liability for defined contribution plans (you don't need to pay an actuary to calculate the lump sum equivalent that you do for defined benefit plans) in practice, defined contribution plans have become generally portable.
In a defined contribution plan, investment risk and investment rewards are assumed by each individual/employee/retiree and not by the sponsor/employer. This risk could be substantial. Based on simulations from security returns over the twentieth century across 16 countries, there is considerable variation in pension fund ratios across both time and country. Those countries keenest on individual DC pension accounts have the highest pension fund ratios (e.g. the UK, the USA) but all investors in all countries face considerable downside risk. Some countries such as France, Italy and Spain face a ten percent probability of having a real replacement ratio of 0.25, 0.20 and 0.17 respectively. In addition, DC scheme participants do not necessarily purchase annuities with their savings upon retirement and bear the risk of outliving their assets. (In the United Kingdom, for instance, it is a legal requirement to use the bulk of the fund to purchase an annuity.)
The "cost" of a defined contribution plan is readily calculated but the benefit from a defined contribution plan depends upon the account balance at the time an employee is looking to use the assets. So, for this arrangement, the contribution is known but the benefit is unknown (until calculated).
Despite the fact that the participant in a defined contribution plan typically has control over investment decisions, the plan sponsor retains a significant degree of fiduciary responsibility over investment of plan assets, including the selection of investment options and administrative providers.
Defined contribution plans are common in the United States, and exist in various other countries, including: the UK’s personal pensions and proposed National Employment Savings Trust (NEST), Germany’s Riester plans, Australia’s Superannuation system and New Zealand’s KiwiSaver scheme. Individual pension savings plans also exist in Austria, Czech Republic, Denmark, Greece, Finland, Ireland, Japan, Netherlands, Slovenia and Spain.
Defined contribution schemes have existed in Japan since October 2001, and as of March 2012 cover more than 4 million workers at about 16,400 companies.
Examples of defined contribution plans in the USA include Individual Retirement Accounts (IRAs) and 401(k) plans. In such plans, the employee is responsible, to one degree or another, for selecting the types of investments toward which the funds in the retirement plan are allocated. This may range from choosing one of a small number of pre-determined mutual funds to selecting individual stocks or other securities. Most self-directed retirement plans are characterized by certain tax advantages, and some provide for a portion of the employee's contributions to be matched by the employer. In exchange, the funds in such plans may not be withdrawn by the investor prior to reaching a certain age—typically the year the employee reaches 59.5 years old—(with a small number of exceptions) without incurring a substantial penalty.
In the United States, the legal definition of a defined contribution plan is a plan providing for an individual account for each participant, and for benefits based solely on the amount contributed to the account, plus or minus income, gains, expenses and losses allocated to the account (see).
Defined contribution plans are subject to IRS limits on how much can be contributed, known as the section 415 limit. In 2013, the total deferral amount, including employee contribution plus employer contribution, is limited to $51,000 or 100% of compensation, whichever is less. The employee-only limit in 2013 is $17,500 with a $5,500 catch-up. These numbers continue to be increased each year and are indexed to compensate for the effects of inflation.
In the UK, over the past several years, the shift from defined benefit (DB) to defined contribution (DC) pension plans has elevated significantly, to the point where many large DB plans are no longer open to new employees. This momentum has been employer-driven, and is considered a response to a combination of factors such as: pension underfunding, declined long-term interest rates and the move to more market-based accounting. The focus is now on managing pension fund assets in relation to liabilities instead of market benchmarks. The Pensions Policy Institute estimates that in 2013 there were approximately 8 million private sector workers building up DC benefits, compared to approximately 1 million building up DB benefits. However, one point of concern with these schemes is that employers often contribute less than what they would under final salary plans. According to the National Association of Pension Funds (NAPF), employers contribute on average 11% of salary into final salary schemes, compared to only 6% into money purchase. This indicates that individuals will have to save more of their own income into a pension fund in order to accomplish a satisfactory retirement income. Companies such as Aon Hewitt, Mercer and Aviva recognise these challenges and have identified the need to help new generations of workers with their retirement funding plans.
- Bureau of Labor Statistics
- Thrift Savings Plan
- Cash balance plan
- Individual Retirement Accounts
- 401(k) plans
- Lemke and Lins, ERISA for Money Managers, §2:26 (Thomson West, 2013).
- "BLS Information". Glossary. U.S. Bureau of Labor Statistics Division of Information Services. February 28, 2008. Retrieved 2009-05-05.
- Cannon, Edmund; Ian Tonks (2012). "The Value and Risk of Defined Contribution Pension Schemes: International Evidence". Journal of Risk and Insurance. doi:10.1111/j.1539-6975.2011.01456.x.
- "401(k)-style plans lure companies". The Japan Times Online. 2012-07-17. Retrieved 2012-07-17.
- Investopedia, Underfunded Pensions Plan. January 2013. http://www.investopedia.com/terms/u/underfunded_pension_plan.asp
- Aon Hewitt, Defined Contribution Survey. December 2013. http://www.aon.com/unitedkingdom/defined-contribution/
- NAPF, Case studies from the changing world of occupational pensions, May 2007. http://www.napf.co.uk/PolicyandResearch/DocumentLibrary/~/media/Policy/Documents/0035_All_change_0507.ashx
- Defined contribution plan in glossary, U.S. Bureau of Labor Statistics Division of Information Services
- Small-business retirement plans, Bankrate
- Not So Golden, Human Resource Executive Online
- How Worthless is Your 401(k)?, Newsweek
- Putnam chief Reynolds leads effort to fix DC plans, Investment News