Definition of Defined Contribution Plan
A defined Contribution Plan is one of the most common and popular methods of pension arrangement between employer and employee. It is a type of retirement plan under which the employer contributes a fixed amount of sum of money which is based on certain factors related to the employee compensation, years in service, and so on and an equal amount is contributed by the employee as well in the employee retirement account which is usually managed by an Independent entity. Any fluctuation in gains or losses arising out of Investment in such an account is the sole responsibility of the employee and the whole investment risk is also taken care of by employees.
Under a Defined Contribution Plan, the employer and employee contribute an equal specified amount which is usually a certain percentage of the employee’s Base Salary to an Independent Retirement Fund Account every month. Investment decisions related to such funds are taken by Fund managers as per the choice undertaken by employees. Regardless of the returns generated by such Funds, the Employer doesn’t have to make good any loss suffered by an employee on account of such Investment returns.
How Does It Work?
Under a typical defined contribution plan, the final returns are uncertain and depend upon the contribution and asset returns which fluctuate based on market performance.
Let’s understand this with a simple example where an employee is contributing a fixed sum of $1000 per year and an equal amount of $1000 is contributed by the employer as well. This amount will get invested every year in a retirement fund and actual returns will depend upon the asset class in which these funds are invested year on year.
Thus defined contribution plan works based on the contribution and return on assets in which funds are invested.
Examples of Defined Contribution Plan
Mr. A was employed by ABC international from 1st Jan 2019 with a fixed emolument of $10000 every month. the fixed contribution made by employees every month as part of the defined contribution plan is 10% i.e. $1000 which is contributed equally by the employer as well.
The contribution is invested in s&p 500 fund by the retirement fund which generates an xirr of 3.94% for the year 2019-20
Detailed contribution and monthly return are shown below:
Thus it can be observed that defined contribution plan returns are dependent on contribution and return on assets.
Types of Defined Contribution Plan
Popular types of defined contribution plan are as follows:
- Plan 401 (K): This is a popular defined contribution plan which involves deferring a part of their salary by the employee who is contributed to this plan. Under this arrangement, the employee has to choose its investment allocation decision on its own. it is provided to an employee who is employed under companies and businesses which are public.
- Plan 403 (B): Another type of plan similar to plan 401 (k) which also provides tax advantage benefits to the investor. It is provided to employees who are employed under a non-profit organization.
- Employee Stock Ownership Plan: As the name suggests itself under this plan employees are provided with stock options based on certain criteria. This is usually common for start-up firms and IT companies.
Besides these plans, there are certain country-specific defined contribution plans which cater to the same purpose. For instance in India, the national pension scheme (nps) is a defined contribution scheme that is tax-efficient and open for enrollment for both private and public sector employees including self-employed people.
How to Invest in Defined Contribution Plan
An employee can contribute to a defined contribution plan in two ways namely:
- As part of the employer-sponsored plan, under which both employee and employer will contribute an equal amount every month.
- Voluntarily as well the employee can contribute to avail income tax benefits which vary from jurisdiction to jurisdiction. For instance in india, an employee can voluntarily contribute an amount equal to rs 50000 and can avail income tax benefit under the relevant section of 80ccd of the income tax act over and above the standard tax exemption limit of rs 150000 available under section 80c of the income tax act.
It offers multiple advantages. Few noteworthy are enumerated below:
- It limits the retirement liability of employers towards employees.
- It reduced the administrative cost for the employer as financial reporting requirements are very less in the case of defined contribution plan and involve a straightforward entry into income statements like pension expenses.
- It is beneficial to the employee as they can decide the investment as per their risk appetite and choice of the asset class.
- Defined contribution doesn’t result in an uncertain liability for the business as it doesn’t form part of the balance sheet, unlike the defined benefit plan.
- It can be withdrawn up to a subject limit on certain occasions such as marriage, house purchase, etc during the lifetime of the employee.
Despite certain advantages, it has certain disadvantages as enumerated below:
- It requires the employee to make investment decisions that may not be possible for all types of employees and may lead to a bad investment decision.
- It doesn’t guarantee and fixed amount of pension unlike defined benefit plan and as such lead to more insecurity for retirement planning.
- It is completely market-driven which makes it prone to market risk.
Defined contribution plan is a straightforward pension plan under which the employer contributes a fixed sum based on certain factors such as compensation, years of service into a third-party managed independent retirement fund account on behalf of the employee. Such funds are managed on behalf of employees and regulated by law. for the employer, this pension plan provides ease of accounting as well as certainty in terms of pension liability unlike defined benefit plan where determining liability is uncertain and for the employee, it provides the freedom to choose as per their investment style and asset allocation preference.
This is a guide to Defined Contribution Plan. Here we also discuss the definition and how does defined contribution plan works? along with advantages and disadvantages. You may also have a look at the following articles to learn more –