Defined contribution plan
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A defined contribution (DC) plan is a type of
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".
Overview
In a defined contribution plan, 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
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.[3] 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.[4] 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.
By country
Defined contribution plans are common in the United States, and exist in various other countries, including: the UK’s personal retirement plans and proposed National Employment Savings Trust (NEST), Germany’s Riester plans, Australia’s Superannuation system, and New Zealand’s KiwiSaver scheme. Individual retirement savings plans also exist in Austria, Czech Republic, Denmark, Georgia, Greece, Finland, Ireland, Japan, Korea, Netherlands, Slovenia and Spain.
United States
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
In such plans, the employee is often responsible 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 defined contribution plans are characterized by certain tax advantages, and some provide for a portion of the employee's contributions to be matched by the employer, either automatically (in the case of safe harbor contributions) or at the employer's discretion. In exchange, the funds in such plans may not be withdrawn by the employee prior to reaching a certain age – typically the year the employee reaches 59.5 years old (with a small number of exceptions, such as retirement before that age) – without incurring a substantial penalty in addition to taxes.
Congress has limited the amount that may be contributed annually to defined contribution plans. For 2023, the total deferral limit (which includes employer contributions, employee contributions to employer sponsored plans, and IRA contributions both deductible and non-deductible) is $66,000 or 100% of compensation, whichever is less, with a separate employee-only limit to employer sponsored plans of $22,500. Employees age 50[5] or over may contribute an additional $7,500 which is not subject to the total deferral or employee limits.[6] The amounts are indexed to compensate for the effects of inflation but increase only in multiples of $500, which means that in some years the amounts do not increase.
United Kingdom
In the
Budget 2014: All tax restrictions on retired people's access to their registered retirement pots are removed, ending the requirement to buy an annuity. The taxable part of the registered retirement pot is taken as cash on retirement to be charged at normal income tax rate(s). The increase in total registered retirement savings that people can take as a lump sum to £30,000.
Germany
Defined contribution plans were introduced in Germany as part of the “Law Strengthening Occupational Pensions” (Betriebsrentenstärkungsgesetz) in July 2017. Prior to the reform, defined contribution plans were illegal and any plan could ultimately trigger a liability for the employer if the plan went into default. These plans can be implemented only by collective bargaining agreements.[10]
Japan
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.[11]
Singapore
The
India
All Government and Private sector organizations had to offer Provident Fund (PF) which is a type of Defined Contribution Plan. The NPS which was started in 2004 is a recent option given to all Central Government employees. The 10% of contribution made by the employer and employees are mandated by the regulations. Additionally employees are given the ability to opt for an additional contribution if they so desire. All contributions are managed by the PF authority. PF authority choose the investment vehicle, however the beneficiaries are given a standard % of returns on their contribution. Some large private sector organizations have also formed their Trust to manage the contributions received from its employees.
See also
- Bureau of Labor Statistics
- Thrift Savings Plan
- Pension
- Cash balance plan
- Retirement
- Individual Retirement Accounts
- 401(k) plans
- Collective trust fund
References
- ^ Lemke and Lins, ERISA for Money Managers, §2:26 (Thomson West, 2013).
- ^ "pension". dictionary.com. July 1, 2015. Retrieved 2016-09-03.
- ^ Webber, David H. (2019). "Reforming Pensions While Retaining Shareholder Voice". Boston University Law Review. 99: 1003. Retrieved 18 November 2019.
- S2CID 7975555.
- ^ So long as the employee turns 50 during a year, whether on January 1 or December 31, an employee may make catch-up contributions at any time during the year.
- ^ https://www.irs.gov/retirement-plans/operating-a-401k-plan#Contributions
- ^ "Investopedia, Underfunded Pensions Plan. January 2013".
- ^ "Aon Hewitt, Defined Contribution Survey. December 2013".
- ^ 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
- ^ "Update on German Pension Law – Germany Introduces Defined Contribution ("DC") Plans" (PDF). November 16, 2017. Archived (PDF) from the original on October 24, 2020. Retrieved October 18, 2021.
- ^ "401(k)-style plans lure companies". The Japan Times Online. 2012-07-17. Retrieved 2012-07-17.
- ^ "CPF LIFE: Managing longevity risk as Singaporeans live longer". Singapore Management University.
- ^ "CPF LIFE: Managing longevity risk as Singaporeans live longer".
External links
- 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
- Putnam chief Reynolds leads effort to fix DC plans, Investment News