What is DEFINED CONTRIBUTION PLAN? What does DEFINED CONTRIBUTION PLAN mean? DEFINED CONTRIBUTION PLAN meaning - DEFINED CONTRIBUTION PLAN definition - DEFINED CONTRIBUTION PLAN explanation.
Source: Wikipedia.org article, adapted under https://creativecommons.org/licenses/by-sa/3.0/ license.
A defined contribution (DC) 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 employee contributions and, if applicable, employer contributions) plus any investment earnings on the money in the account. 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, 26 U.S.C. § 414(i) 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."
While Defined Contribution plans are sometimes referred to as pensions, they are not. The word "pension" is defined as "a fixed amount, other than wages, paid at regular intervals to a person or to the person's surviving dependents in consideration of past services". In contrast, a Defined Contribution retirement plan is an arrangement where an employer, during the time a person is employed, puts money in a registered retirement account on the employee's behalf. In general, a DC plan provides much less security for the employee, and much less obligation for the employer, than a pension.
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 plans 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 (no actuary is needed to calculate the lump sum equivalent unlike 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 retirement plan fund ratios across both time and country. Those countries keenest on individual DC accounts have the highest retirement plan fund ratios 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.
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.