Defined-contribution plan

A defined contribution plan is a retirement savings plan in which the employee and/or the employer contribute to the employee’s account under the plan. The amount in the account at distribution includes contributions and investment earnings or losses, minus any investment and administrative fees. The employee is not guaranteed a specific benefit amount upon retirement.

In a defined contribution plan, employees are responsible for:

• Deciding whether to participate in the plan
• Choosing what percentage of their salary to contribute
• Selecting investments for their account (not all plans allow this)

What are the benefits of a defined contribution plan?

Employees save for retirement by contributing a portion of their paycheck to their account. Additionally, employees can also receive contributions from their employer via a match or profit-sharing contribution, depending on plan provisions. Some of the main benefits include:

• Tax benefits: Contributions to a defined contribution plan are tax-advantaged. In a 401(k) plan, your contributions can be made using pre-tax or Roth (after-tax) deferrals. Pre-tax contributions lower your current taxable income, and both your contributions and earnings are tax-deferred until you withdraw the money. Roth deferrals are made after taxes, but withdrawals on the earnings are tax-free if certain qualifications are met.

• Control over investments: An individual can choose the investments that best suit their needs. This option is available with most 401(k) plans but is not guaranteed.

• Flexibility: According to most plan documents, an individual can change their contributions as their needs change.

• Cost-effective for employers: Employer contributions to 401(k) plans can be required or optional, depending on the plan design, but they are usually less than required contributions to a traditional pension plan.

How can third-party administrators and recordkeepers help with fiduciary responsibilities?

Companies that sponsor 401(k) plans are fiduciaries to the plan and are responsible for all aspects of plan administration. They often outsource plan administration responsibilities to a third-party administrator or recordkeeper. Some of these service providers will also agree to make some fiduciary decisions for the plan as a “3(16) Plan Administrator.”

It is important for the sponsor to understand what services the provider offers and what fiduciary responsibilities remain with the sponsor. Sponsors can also work with specialist investment providers to help manage their defined contribution plans investment options through a 3(21) or 3(38) fiduciary relationship.

What are the disadvantages of a defined contribution plan?

Some of the risks associated with defined contribution plans are:

• Investment risk: Because contributions are generally invested in the stock and bond markets, they're subject to market volatility and investment risks. A significant market crash could reduce retirement savings.

• Fees: Most defined contribution plans have fees deducted from participant accounts, including plan administration fees, investment fees, and individual service fees. Over time, fees can decrease your return. Plan fiduciaries are required to determine that these fees are reasonable.

• Limited investment options: The investment options available in a defined contribution plan may be limited by the funds offered by the employer. Additionally, participants bear the ultimate risk of loss due to investment performance.

• Vesting: Some defined contribution plans require employees to remain with the company for a number of years before they fully own employer contributions.

The bottom line

Defined contribution plans can offer employees an effective way to save for retirement by enabling them to contribute a portion of their paycheck, often with the benefit of employer contributions and tax advantages. These plans can provide flexibility in investment choices and contribution levels, allowing employees to tailor their retirement savings to their individual needs. However, participants may also face certain risks, including market volatility, plan fees, and limited investment options.

Article Reviewed By

Vicki Waun
Vicki Waun, QPA, QKC, QKA, CMFC, CRPS, CEBS, CPC, is a Senior Legal Product Analyst at Human Interest and has over 20 years experience with recordkeeping qualified plans, along with extensive experience in compliance testing. She earned her BSBA in Accounting from Old Dominion University and is a member of ASPPA.