In a defined contribution plan, you and your employer each contribute a specified amount to your individual account, which is then invested in one of several professionally designed and managed funds. 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. The IRS typically refers defined contribution plans as 401(a), 403(b), or 457 depending on when the retirement plan was established and whether or not it is supplemental to some other retirement benefit.
In a defined contribution plan (DC), you and your employer each contribute a predetermined, or “defined,” amount to your individual account, which is then invested in one of several professionally designed and managed funds. 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.
These plans—known by a range of technical names such as 401k, 401a, 403b or 457 plans—provide an individual account where you can choose the investment strategy for all contributions made by you and your employer. You can select an investment strategy based on your own risk tolerance and retirement goals, but you typically do not manage the investments yourself.
The early 401(k) plans in the 20th century required people to figure out their own portfolios—a very difficult undertaking. Today, the most common approach in the private sector is to use pre-designed retirement funds from groups like Vanguard, Fidelity, Northwest Mutual, Lincoln Financial, TIAA, etc.
For a DC plan to provide you with adequate retirement savings, there need to be sufficient contributions flowing into your account each pay period. The common rule of thumb is that there should be at least 10% of your regular salary contributed into your DC account every year, and ideally 12% to 15%. If you don’t have access to Social Security, the regular monthly contribution would need to be 15% to 20% of your salary.
You don’t need to contribute this full amount, 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.
A good defined contribution plan will automatically enroll participants into a professionally managed investment fund with low fees, as well as more risk early in an individual’s career and less risk near the end. That means public employees with DC plans don’t have to make investment choices for themselves if they don’t want to or don’t feel equipped, and they won’t get shoved into a risky investment program with high fees. A retirement system’s administrators can protect its members by working directly with financial companies to make sure public employees don’t get taken advantage of. 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, but without a guarantee of any specific investment return on additional contributions.
A Typical Example:
- Employees contribute 3-5% of their paychecks into a personal, DC account.
- Employers provide a similar 3-7% match and contribution on top of this into the individual’s DC account (for a total of 10% to 12% from employee and employer combined).
- 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.
- Colorado’s DC plan requires a 10% member contribution and provides an 11% employer contribution — higher rates than most because employees are not enrolled in Social Security.
- Employees are automatically enrolled in the retirement plan so that they do not miss out.
- Employee accounts are set up where 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:
There are various ways that retirement benefits can be offered. Each can be measured against different kinds of objectives. Here is how DC plans compare to other retirement plans on a few common goals that states and local employers have for offering retirement benefits in the first place.