Defined-Contribution Plan

A defined-contribution (DC) plan is a retirement plan in which the amount of the annual contribution is specified. The most common type of DC plan is the 401(k) plan. These plans are a popular alternative to the traditional defined-benefit (DB) pension plans that were once the standard form of retirement plan offered by employers.

Structure of Defined-Contribution Plans

In a defined-contribution plan, the employee, employer, or both make contributions on a regular basis. The final benefits received by the participant depend on the amount contributed and the gains (or losses) of the investments. The contributions can be made from the employee’s pretax income or as a part of employee compensation in a post-tax format, subject to applicable tax laws.

Unlike defined-benefit plans, where retirees receive a predetermined monthly amount, defined-contribution plan participants have accounts where the contributions and the investment gains accumulate. The eventual value of the retirement fund depends on the amounts contributed and the success of investments over time.

Comparison with Defined-Benefit Plans

Types of Defined-Contribution Plans

401(k) Plans

Named after the section of the tax code that governs them, 401(k) plans are the most widespread type of defined-contribution plans in the United States. Usually, both employees and employers can make contributions. Employers may also offer matching contributions.

403(b) Plans

403(b) plans are similar to 401(k) plans but are tailored for employees of public schools, certain non-profits, and some clergy members.

457 Plans

457 plans are available for state and local public employees and certain non-profit organizations. These plans have many features alike to 401(k) plans, but the contributions do not impact other retirement plan limits.

Thrift Savings Plans (TSP)

The Thrift Savings Plan is a defined-contribution plan for federal employees and members of the uniformed services, including the military. It offers similar benefits to private-sector 401(k) plans.

SIMPLE and SEP IRA Plans

These plans are intended for small businesses and self-employed individuals. SIMPLE IRA plans allow both employee and employer contributions, while SEP (Simplified Employee Pension) IRAs are funded primarily by the employer.

Contribution Limits

For defined-contribution plans, there are often limits on how much an individual can contribute initially and on an ongoing basis. For instance, the IRS sets annual contribution limits for 401(k) plans, which are updated periodically. In 2023, the contribution limit for employees participating in 401(k) plans was $22,500, with an additional “catch-up” contribution limit of $7,500 for employees over 50 years of age.

Investment Choices

Participants in defined-contribution plans can generally direct their own investment choices among the options provided by the plan. These options might include various mutual funds, stocks, bonds, money market funds, and other investment products. The available investment choices typically impact the range of potential returns and risks within the plan.

Plan providers often offer resources to assist employees in making informed investment decisions, including educational materials, financial advice, and online tools that provide wealth modeling and projection.

Fiduciary Responsibility

Defined-contribution plans are governed under the Employee Retirement Income Security Act (ERISA) in the United States, which imposes several fiduciary responsibilities on the plan sponsors and managers. These fiduciaries are legally obligated to act in the best interests of the plan participants and beneficiaries. They must ensure that the plan’s expenses are reasonable and that the investment options provided are diverse — allowing participants to diversify their investments to mitigate risk.

Pros and Cons of Defined-Contribution Plans

Pros

Cons

Leading Companies and Plan Providers

Vanguard

Vanguard is one of the largest providers of defined-contribution plans in the United States. They offer a range of plans and investment options, with a strong emphasis on low-cost index funds. Vanguard

Fidelity Investments

Fidelity is another major player in the retirement plan market, offering a suite of defined-contribution plan services, including 401(k), 403(b), and 457 plans. They provide a broad array of investment options and robust financial planning and advisory services. Fidelity Investments

T. Rowe Price

T. Rowe Price focuses on providing diverse retirement plan options with strong customer service and investment management capabilities. They manage various types of defined-contribution plans, offering considerable support and resources to plan sponsors and participants. T. Rowe Price

Charles Schwab

Charles Schwab provides defined-contribution plan services focusing on offering flexibility and robust participant education resources. They offer plans that allow extensive customization and self-directed investment options. Charles Schwab

Empower Retirement

Empower Retirement is known for its comprehensive retirement services and broad spectrum of plans, including 401(k), 403(b), and governmental 457 plans. They emphasize strong plan management and participant engagement. Empower Retirement

Conclusion

Defined-contribution plans have evolved to become one of the primary vehicles for retirement savings. They offer flexibility and control for employees, making them appealing in the modern employment landscape. Employers also benefit from simplified administration and the ability to offer competitive benefits. However, the shift of investment risk from the employer to the employee highlights the importance of financial literacy and smart investment decisions to ensure secure retirement outcomes. As the landscape of retirement planning continues to evolve, the defined-contribution plan remains a critical tool in securing financial futures.