A defined contribution plan, or a DC plan, is an employer-sponsored retirement savings vehicle that does not link the number of an employee's benefits to their salary. Instead, the contributions are invested on behalf of the employees and then reallocated as needed to meet future financial needs. In most cases, those needs will be retirement-related.
In a typical DC program, an investment account is opened for each participant, and money contributed by both the employer and the employee goes into this account. The money in these accounts can be invested in various funds – including mutual funds – which offer different types of risk and returns depending upon what you choose. Then, once you retire from your job, the money is used to supplement your income or be withdrawn to pay whatever expenses you have.
As with any financial product, DC plans come in many shapes and sizes depending upon how they are structured by the employer and the employee, who can change some of their allocations. This flexibility makes these plans particularly attractive since individuals can make decisions about their retirement savings on their own time based on their needs at that specific time. And since the money is always available to them, they don't have to worry about whether they will access it when they need it.
Why defined contribution plan?
The three major reasons for switching from a traditional pension system into a DC plan are Flexibility, Control, and Auto-Enrollment.
1. Flexibility: The DC plan offers great flexibility to the participant. He can invest in different fund options and choose asset allocation to match his risk profile and investment horizon.
2. Control: The participant has more control over their money investments under a DC plan than any other retirement account option available. On the other hand, under a defined benefit plan, there is no freedom of choice since your retirement money is built into an annuity that can only be changed at certain times throughout your life (usually every five years). While you may be able to make some adjustments during those times, most people do not change anything because they don't want to risk what might happen. The DC plan allows you to have complete control over your retirement savings, and you can adjust them at any time you want based on your needs.
3. Auto-Enrollment: The automatic enrollment option is a great way to increase the number of workers who save for their future in a DC plan because it eliminates the participant's need for an initial investment decision. In most cases, companies enroll all new employees into a specific percentage contribution program unless they decide otherwise. This means that even if the employee would never have opted to contribute, they will automatically be saving money in their account at a certain default rate, which increases every year until the auto-enrollment period ends, typically when they are invested, usually in their 3rd year of employment.
What are the key features of a defined contribution plan?
The three main features in a DC plan are:
Participation, Contribution, and Vesting.:
1. Participation: Participation is required at all times to take part in the plan. The level of participation can vary from employer to employer. Still, it generally means that eligible employees must make elective deferrals and an employer contribution every time they earn wages. After you're fully vested, any money you leave in your account will become your property, so even if you decide to quit working for your employer, you cannot withdraw this until retirement age, when the money will be yours to use.
2. Contribution: In a defined contribution plan, there is no set formula for employer contribution aside from the fact that they usually make an annual matching contribution based upon either your invested money or your elective deferrals to encourage you to save for the long term. Employers sometimes make additional contributions when they see fit, but these are often discretionary and can change each year.
3. Vesting: Vesting refers to the amount of time you need to work before you are entitled to all of your earnings under a DC plan or portion thereof. This will typically range anywhere from 3-7 years, depending on how it's structured by the employer, where at least 50% of any vested earnings must be available to you upon separation of service. If your employer leaves the plan intact and does not require any written requests to maintain the account balance, 100% of any vested balances must be distributed at retirement or termination of employment.