Defined Contribution Plan

As an HR professional, you have to familiarize yourself with many concepts and terminologies within the human resources scope, and one of the terms is called a defined contribution plan. This term refers to a type of retirement savings plan that is offered by an employer. So, it’s important for you to understand the concept so that both employers and employees can make informed decisions about choosing a savings plan for their retirement.

Defined Contribution Plan

Definition of Defined Contribution Plan

A defined benefit plan is a retirement plan sponsored by an employer, where the benefits are calculated using a formula that takes into account factors such as length of employment and salary history. The company is in charge of managing the plan’s investments and risks, and will often hire an external investment manager to do so. This type of plan is known as “defined benefit” because the formula for calculating retirement benefits is known in advance by both employees and employers, who use it to determine and establish the benefit to be paid.

Benefits can be paid out as fixed monthly payments, similar to an annuity, or as a lump sum. If the employee dies, their surviving spouse is usually entitled to the benefits. Since the employer is responsible for making investment decisions and managing the plan’s investments, they assume all investment and planning risks.

Employee Contributions

In this plan, employees are required to contribute a certain percentage of their salary into the retirement savings plan. These contributions are deducted from the employee's gross salary and are made on a pre-tax basis, which means they are not subject to income tax at the time of contribution.

Employer Contributions

The employer is responsible for ensuring that a specific retirement benefit amount is funded and guaranteed for each participant. To fund the plan, the employer typically contributes a regular amount, often a percentage of the employee’s salary, into a tax-deferred account. Depending on the plan, employees may also contribute. The employer’s contribution is effectively deferred compensation. If there are poor investment returns or incorrect assumptions and calculations, there may be a funding shortfall, in which case the employer is legally required to make up the difference with a cash contribution.

Investment Options

The contributions made by both the employee and the employer are invested in various investment options offered within the plan. These investment options can include mutual funds, stocks, bonds, and other investment vehicles. The employee typically has the ability to choose how their contributions are invested, based on their risk tolerance and financial goals.

Vesting

Vesting refers to the employee’s entitlement to the contributions made by their employer towards their Defined Contribution Plan. In such a plan, vesting can either be immediate or gradual. With immediate vesting, the employee has complete ownership of both their own contributions and those made by their employer from the outset. On the other hand, with gradual vesting, the employee’s entitlement to their employer’s contributions increases over time, usually based on their years of service with the company.

Retirement Benefit

The final retirement benefit in a Defined Contribution Plan is influenced by the performance of the investments made using the contributions. The value of the account is dependent on various factors such as the return on investment, the duration for which the contributions have been invested, and the rate of contribution by the employee. Upon retirement, the employee has the option to choose how they would like to receive their benefit, which could include a lump-sum distribution, periodic payments, or a combination of both.

Conclusion

Employees can contribute a portion of their salary to a retirement account in this type of plan. Employers often match these contributions. The funds in the account are invested, and the employee's retirement income depends on the investments' performance. HR professionals need to understand defined contribution plans to offer comprehensive benefit packages and help employees achieve long-term financial goals.