Defined contribution pension plan
Defined contribution pension plan (DC plan) is a type of Pension plan in which the contributions made to an individual's retirement account are specified according to a predetermined formula or arrangement, while the amount of retirement benefits ultimately received depends on factors such as contributions, investment performance, fees, and the timing and form of withdrawals.
Unlike a Defined benefit pension plan, a defined contribution plan generally does not guarantee a predetermined retirement benefit. The investment and longevity risks are therefore generally borne primarily by the plan participant, although the allocation of risks depends on the specific design of the pension arrangement.
Structure
A defined contribution pension plan generally involves:
- contributions made by an employee, employer, or both;
- an individual account or an accounting allocation representing the participant's accumulated contributions;
- investment of the accumulated assets;
- investment returns or losses;
- retirement distributions according to the plan's rules.
The accumulated retirement value can be represented conceptually as:
The actual calculation depends on the specific plan and applicable rules.
Contributions
Contributions may be made by:
- employees;
- employers;
- both employees and employers.
Contribution levels may be specified as a fixed amount, a percentage of salary, or according to another formula.
Employer contributions may be subject to conditions such as employment requirements, contribution limits, or vesting rules.
Investment of contributions
Contributions are generally invested in accordance with the investment options available under the pension plan.
Possible investments may include:
- equities;
- bonds;
- money-market instruments;
- mutual funds;
- target-date funds;
- other permitted investments.
The investment choices available to participants depend on the structure of the plan and applicable regulations.
Investment risk
In a defined contribution plan, the retirement balance is generally affected by the performance of the underlying investments.
If investments increase in value, the participant's retirement account may increase. If investments decline in value, the account may decrease.
Investment risk is therefore generally borne primarily by the participant rather than the plan sponsor.
Retirement benefit
The retirement benefit is not normally predetermined in the same way as under a defined benefit plan.
The eventual benefit depends on factors including:
- total contributions;
- employer contributions;
- investment performance;
- fees and expenses;
- length of participation;
- timing of contributions;
- withdrawals;
- retirement age;
- distribution method.
Defined contribution versus defined benefit
A defined contribution plan differs from a Defined benefit pension plan primarily in how retirement benefits are determined.
| Feature | Defined contribution plan | Defined benefit plan |
|---|---|---|
| Contributions | Generally specified according to the plan | May vary according to funding requirements |
| Retirement benefit | Generally depends on accumulated assets | Determined according to a benefit formula |
| Investment risk | Generally borne primarily by the participant | Generally borne primarily by the plan sponsor |
| Longevity risk | Generally borne primarily by the participant | Generally borne primarily by the plan sponsor |
| Funding | Contributions are allocated to participant accounts | Contributions are used to finance promised benefits |
The precise allocation of risks varies according to the design and legal framework of the pension arrangement.
Vesting
Vesting determines when a participant obtains a non-forfeitable right to employer contributions.
Employee contributions are generally treated differently from employer contributions under applicable plan rules.
Vesting arrangements can influence the retirement benefits available to employees who leave employment before retirement.
Portability
Defined contribution plans can generally provide greater portability than traditional defined benefit arrangements because retirement savings may be associated with an individual participant's account.
The extent of portability depends on the applicable pension system and plan rules.
Participants who change employers may have options such as:
- leaving accumulated assets in the existing plan;
- transferring assets to another qualifying retirement arrangement;
- receiving a permitted distribution.
The available options vary by jurisdiction.
Fees and expenses
Fees and expenses can reduce the amount accumulated for retirement.
They may include:
- investment-management fees;
- administrative expenses;
- transaction costs;
- advisory fees.
Because contributions and investment returns accumulate over long periods, differences in fees can have a significant effect on the eventual account balance.
Investment strategy
Participants may select among investment options according to the plan's rules.
An Investment strategy may consider:
- investment horizon;
- risk tolerance;
- diversification;
- expected retirement date;
- liquidity requirements.
Younger participants may have a longer investment horizon, while participants approaching retirement may place greater emphasis on preserving accumulated capital and managing volatility.
Portfolio management
Portfolio management within a defined contribution plan involves selecting and monitoring investments in accordance with the participant's objectives and the investment options available.
Some plans provide professionally managed portfolios or target-date investment options to simplify investment decisions for participants.
Target-date funds
Target-date funds are investment funds designed around an approximate future retirement date.
The asset allocation of such a fund may gradually become more conservative as the target date approaches.
They are commonly offered as investment options in defined contribution pension arrangements.
Retirement distributions
At retirement, accumulated assets may be distributed according to the rules of the pension arrangement and applicable law.
Possible forms of distribution may include:
- periodic withdrawals;
- lump-sum payments;
- annuity payments;
- combinations of these approaches.
The available distribution methods vary by jurisdiction and plan design.
Tax treatment
Defined contribution pension plans may receive tax treatment intended to encourage retirement saving.
Depending on the jurisdiction, tax advantages may apply to:
- employee contributions;
- employer contributions;
- investment earnings;
- retirement distributions.
The specific tax treatment varies substantially among countries and types of pension plans.
Advantages
Defined contribution plans can provide:
- transparent accumulation of retirement savings;
- portability in many pension systems;
- flexibility in investment choices;
- employer and employee contribution mechanisms;
- the potential for long-term investment growth.
They can also reduce the long-term funding uncertainty faced by employers compared with plans that guarantee a predetermined retirement benefit.
Limitations
Defined contribution plans expose participants to several risks, including:
- investment risk;
- inflation risk;
- longevity risk;
- sequencing risk;
- insufficient contributions;
- high fees;
- the risk of retiring during unfavorable market conditions.
The retirement income generated by the accumulated assets may therefore be uncertain.
Example
Suppose an employee contributes US$500 per month to a defined contribution pension account and the employer contributes an additional US$250 per month.
The total monthly contribution is:
The account balance will subsequently depend on the contributions, investment returns, fees, withdrawals, and length of participation.
Unlike a defined benefit plan, the employee does not necessarily receive a predetermined pension based on salary and years of service.
Importance
Defined contribution pension plans are an important form of retirement savings arrangement in which the accumulation of retirement assets is separated from the promise of a predetermined pension benefit. By specifying contributions while allowing the eventual retirement value to depend on investment performance and other factors, these plans place a significant portion of investment and retirement-income risk on participants.