A defined contribution plan is a retirement plan in which you and your employer each contribute a specified amount of money to your individual account. That money is then invested in one or more professionally designed and managed funds.
Many of these accounts allow you to choose whether to convert retirement savings from your working years into a lump sum, a guaranteed monthly pension check (called an annuity), or a combination of both.
Equable Insights
- Defined Contribution Plan: A type of employer-sponsored retirement plan funded by employee and employer contributions
- Defined Contribution vs. Defined Benefit: Unlike defined benefit (pension) plans, defined contribution plans do not promise a specific level of guaranteed retirement income by default.
- Best For: Public employees who have a pension and the option of contributing to an employer-sponsored defined contribution plan, such as a 403(b)
What Is a Defined Contribution Plan and How Does It Work?
The IRS typically refers to defined contribution plans according to the section of the Internal Revenue Code that governs them. For example, 401(k), 401(a), 403(b), and 457(b) plans are different sections of IRS tax code.
These plans allow you (the employee) to choose the investment strategy for all contributions made by you and your employer. The most common investment options are mutual funds, including target-date funds, index funds, and asset allocation funds.
Early 401(k) plans required employees to construct and manage their own portfolios — a very difficult undertaking. Today, the most common approach in the private sector is to use mutual funds from groups like Vanguard and Fidelity.
Employee and Employer Contribution Rates
For DC plans to provide adequate retirement savings, it needs sufficient contributions flowing into your account each pay period. The common suggestion is to contribute at least 10% (ideally, 12% to 15%) of your salary to the account annually. If you don’t have Social Security access, the regular monthly contribution should be 15% to 20% of your salary.
Employees don’t need to contribute this full amount, however, as your employer will also make contributions. In the private sector, employers typically provide matching benefits to whatever you contribute (up to a cap). In the public sector, there are a mix of strategies depending on the state. Some states provide adequate contributions, and others don’t.
Investment Options and Target-Date Funds
A well-designed defined contribution plan will automatically enroll participants into a professionally managed investment fund with low fees. This is often a target-date fund. These funds utilize a glide path to invest in riskier assets, like stocks, early in an individual’s career and more conservative assets, like bonds, near the end. That means public employees with DC plans don’t have to make investment choices for themselves if they don’t feel equipped. This also prevents employees from getting into risky investment programs with high fees.
A retirement system’s administrators can protect its members by working directly with financial companies to ensure they don’t take advantage of public employees. That is exactly what Michigan, Utah, Florida, and other public-sector DC plans do for their members.
Defined contribution plans also allow you the flexibility to change your own contribution as your finances allow. However, there is no guarantee of any specific investment return on additional contributions.
Example: Defined Contribution Plan
- Employees contribute 3%-5% of their paychecks into a personal, defined contribution plan account.
- Employers provide a similar 3%-7% match and contribution on top of this into the individual’s DC account (for a combined total of 10% to 12%).
- South Carolina’s DC plan requires a 9% member contribution, matched with a 5% employer contribution.
- Michigan’s DC plan provides a minimum 4% employer contribution and then matches an additional 3% of member contributions for a starting amount of 10% of salary.
- Employees automatically enroll in the retirement plan to ensure they participate in saving for retirement.
- Employee accounts are set up in which investments are defaulted into a qualified portfolio like a target-date fund.
- Employees are given the option to convert their retirement savings into guaranteed income through an “annuity” product upon reaching retirement age.
The Pros and Cons of Defined Contribution Plans
Compared to defined benefit plans, hybrid plans, and guaranteed return plans, defined contribution plans have several key pros and cons.
Pros
- Can provide retirement income security if the plan design is focused on income replacement generally, with lifetime income options available within the plan and adequate contributions
- Funding and budgetary predictability
- Full portability; usually best for short- to medium-term employees (15 to 20 years of service)
- No funding risk; cannot develop unfunded liabilities
Cons
- May not provide adequate retirement income security if total contributions are less than 10%-15% of salary
- Limited effect on retention, depending on contribution levels
- Employee investment risk
Frequently Asked Questions (FAQs)
In a defined contribution plan, employers and employees contribute a defined amount, such as 3%-5% of the employee’s paycheck with a 3%-7% employer match. In a defined benefit plan, a pension formula (years of service X multiplier X final average salary) defines the amount of the retirement benefit.
In order for a defined contribution plan to provide adequate levels of income in retirement, professionals commonly recommend that individuals contribute at least 10% of their annual salary to the account each year. Ideally, individuals will contribute 12% to 15% annually. And for those who don’t have access to Social Security, it may be necessary to up increase contributions to 15% to 20% of their salary.
Yes, but typically not by default. Employees are often given the option to convert their defined contribution retirement savings account into an “annuity” product upon reaching retirement age, which can provide guaranteed income stream similar to a pension.
