Defined-Contribution Pension Plan

Overview

A Defined-Contribution Pension Plan is a retirement savings plan where contributions are consistently fixed, but the eventual retirement benefit depends on the investment performance of the contributed funds. These plans are popular because they shift investment risk from employers to employees and provide employees with various investment options.

Key Features

Fixed Contributions: Contributions are set and typically do not vary significantly, apart from employee-selected contribution rates.
Employee Control: Employees usually have control over their investment options within the plan.
Tax-Deferred Growth: Contributions and investment growth are often tax-deferred, meaning taxes are only paid upon withdrawal.

Examples

401(k) Plans: Employees contribute a portion of their salary pre-tax into a retirement account, often with employer matching.
403(b) Plans: Similar to 401(k) plans but catered towards employees of public schools and non-profit organizations.
457 Plans: Retirement plans intended for state and local government employees and some non-profit employees.

Frequently Asked Questions

Q1: How is a defined-contribution plan different from a defined-benefit plan? A1: In a defined-contribution plan, the contributions are fixed, and benefits vary based on investment returns. In a defined-benefit plan, retirement benefits are predetermined and guaranteed by the employer, regardless of investment performance.

Q2: Can employees choose how much to contribute to their defined-contribution plan? A2: Yes, employees can typically choose their contribution rate within a range specified by their employer.

Q3: Do employers match contributions in defined-contribution plans? A3: Some employers match contributions up to a certain percentage, but it varies by employer.

Q4: What are the investment options in a defined-contribution plan? A4: Common options include stock funds, bond funds, and money market accounts.

Q5: When can employees withdraw from their defined-contribution plan? A5: Employees can generally start withdrawing from their retirement plan without penalties after the age of 59½.

Defined-Benefit Pension Plan: A retirement plan where benefits are fixed and based on factors such as salary history and duration of employment.
Tax-Deferred: Investment earnings such as interest, dividends, or capital gains that accumulate tax-free until the investor takes possession of the gains.
Vesting: The process by which an employee earns the rights to employer-contributed funds in a retirement plan.

Online References

Suggested Books for Further Studies

“The 401(k) Handbook” by W. Scott Simon: Provides a detailed guide to understanding and managing 401(k) retirement plans.
“Retirement Plans: 401(k)s & IRAs” by Twila Slesnick and John C. Suttle: A comprehensive resource about various retirement plans including 401(k) and IRAs.
“Pension Revolution: A Solution to the Pensions Crisis” by Keith P. Ambachtsheer: A look into the evolution and future of pension plans, including defined contribution plans.

Fundamentals of Defined-Contribution Pension Plan: Pension Planning Basics Quiz

### In a defined-contribution plan, what determines the final benefit? - [ ] Fixed amount set by employer - [x] Investment returns - [ ] Employee's age - [ ] Length of employment > **Explanation:** In a defined-contribution plan, the final benefit is primarily determined by the returns on the investments made with the contributions. ### Which plan allows contributions from both the employee and sometimes the employer? - [x] 401(k) - [ ] Defined-benefit plan - [ ] Roth IRA - [ ] Health Savings Account > **Explanation:** A 401(k) plan allows contributions from both employees and sometimes matching contributions from employers. ### What is a primary reason companies prefer defined-contribution plans over defined-benefit plans? - [x] Limits pension liabilities - [ ] Guarantees employee investment success - [ ] Ensures higher retirement benefits - [ ] Provides immediate liquidity > **Explanation:** Companies prefer defined-contribution plans as they limit their pension liabilities and transfer the investment risk to employees. ### Which of the following is a common type of defined-contribution plan for non-profit organizations? - [ ] 401(k) - [x] 403(b) - [ ] IRA - [ ] Social Security > **Explanation:** A 403(b) plan is a common type of defined-contribution plan specifically targeted at employees of public schools and non-profit organizations. ### At what age can employees generally start withdrawing from a defined-contribution plan without penalties? - [ ] 55 - [ ] 58 - [x] 59½ - [ ] 62 > **Explanation:** Employees can typically begin withdrawing from their defined-contribution plan without penalties at the age of 59½. ### What tax treatment do contributions in most defined-contribution plans receive? - [x] Tax-deferred - [ ] Tax-exempt - [ ] Immediate taxation - [ ] Tax-deductible only at withdrawal > **Explanation:** Contributions in most defined-contribution plans grow tax-deferred, meaning taxes are paid only upon withdrawal. ### What flexibility do employees have in defined-contribution plans regarding investments? - [x] They can choose from multiple investment options. - [ ] They must stick to employer-chosen investments. - [ ] Investment options are limited to government bonds. - [ ] None, contributions sit in a holding account. > **Explanation:** Employees in defined-contribution plans often have the flexibility to choose from a variety of investment options, such as stock, bond, and money market funds. ### How do employer contributions usually work in a defined-contribution plan? - [ ] Employers do not contribute. - [ ] Employers fully fund the plan. - [x] Employers may match employee contributions. - [ ] Contributions are mandatory for employers. > **Explanation:** Employers often match employee contributions up to a certain percentage, encouraging employee savings. ### What is a common reason for the increased popularity of defined-contribution plans? - [ ] Guaranteed high returns - [ ] Simplicity in withdrawal - [x] Controlled company pension outlay - [ ] Annual fixed benefits > **Explanation:** Defined-contribution plans have become more popular because they allow companies to control their pension outlay by fixing contribution rates and shifting investment risk to employees. ### What term describes the process of an employee earning the right to employer contributions in their retirement plan? - [ ] Deferring - [x] Vesting - [ ] Matching - [ ] Rolling over > **Explanation:** Vesting refers to earning the rights to employer-contributed funds in a retirement plan based on certain criteria like service duration.

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