Defined-Contribution Pension Scheme
A defined-contribution (DC) pension scheme is a retirement plan where the benefits are directly based on the contributions made by the scheme member and employer, along with investment returns. Unlike a defined-benefit (DB) pension scheme where the retirement benefits are predetermined and calculated through formulas considering factors like salary and tenure, the value of a DC pension scheme depends on the amount of money contributed and the performance of the invested funds.
Key Attributes:
- Contributions: Members and their employers contribute a specific amount periodically.
- Fund Accumulation: Contributions are invested in a variety of financial products such as stocks, bonds, and mutual funds over time.
- Retirement Benefits: Upon retirement, the benefits are determined by the total contributions and investment returns accumulated in the pension fund.
- Annuity Purchase: At retirement, members may use the accumulated fund to purchase an annuity, which will provide a regular pension income.
Examples:
- 401(k) Plans: Popular in the United States, employees and employers make contributions, which are invested in financial markets.
- Individual Retirement Accounts (IRAs): Contributions made by individuals with tax advantages, which grow based on investment performance.
- Occupational or Employer-Sponsored Plans: Contributions are made by both the employer and the employee, managed by a pension provider.
Frequently Asked Questions (FAQs)
Q: What distinguishes a defined-contribution pension scheme from a defined-benefit pension scheme?
- A: In a defined-contribution scheme, the pension received depends on the contributions and investment returns. In contrast, a defined-benefit pension scheme provides predefined retirement benefits typically based on salary and years of service.
Q: How are contributions invested in a DC pension scheme?
- A: Contributions are typically invested in various financial instruments, including stocks, bonds, mutual funds, and other investment vehicles.
Q: What happens to my DC pension fund if I change jobs?
- A: Most DC schemes are portable, meaning you can transfer your accumulated pension fund to a new employer’s scheme or into a personal pension arrangement.
Q: Are there any tax advantages to contributing to a DC pension scheme?
- A: Yes, many countries provide tax incentives for pension contributions, such as tax deductions or deferred taxes on investment growth until withdrawal at retirement.
Q: Can I choose how my contributions are invested?
- A: Many DC pension schemes offer members a choice of investment options. However, the level of control can vary depending on the specific scheme.
Related Terms
- Defined-Benefit Pension Scheme: A retirement plan where the benefits are predetermined and calculated based on factors such as salary history and years of service.
- Annuity: A financial product that provides a regular income stream, typically for life, purchased with the accumulated funds at retirement.
- Pension Fund: A pool of assets forming an independent legal entity, which is used to pay out retirement benefits.
Online References
Suggested Books for Further Studies
- “The Pension Answer Book” by Stephen J. Krass: Comprehensive guide to pension and retirement plan issues.
- “Pension Revolution: A Solution to the Pensions Crisis” by Keith P. Ambachtsheer: Insights into modern pension scheme designs.
- “Retirement Plans: 401(k)s, IRAs and Other Deferred Compensation Approaches” by Allen S. Altman: Detailed analysis of various retirement savings plans including DC schemes.
Accounting Basics: “Defined-Contribution Pension Scheme” Fundamentals Quiz
### What does a defined-contribution (DC) pension scheme primarily depend on for determining the retirement benefits?
- [ ] Predetermined formulas based on salary and years of service.
- [x] The total contributions made and the investment performance.
- [ ] Government set pension rates.
- [ ] Corporate profits.
> **Explanation:** In a defined-contribution pension scheme, retirement benefits are based on the total contributions made by the member and the investment returns on those contributions.
### Who contributes to a defined-contribution pension scheme?
- [ ] Only the employer.
- [ ] Only the employee.
- [x] Both the employee and the employer.
- [ ] Government agencies.
> **Explanation:** Typically, both the employee and the employer make contributions to a defined-contribution pension scheme.
### What can the accumulated fund of a DC pension scheme be used for upon retirement?
- [ ] Buying government bonds.
- [ ] Purchasing a new home.
- [x] Purchasing an annuity to provide regular pension income.
- [ ] Paying off student loans.
> **Explanation:** Upon retirement, the accumulated funds in a DC pension scheme are often used to purchase an annuity, which will provide regular pension income.
### How portable are defined-contribution pension schemes?
- [x] Most are portable, allowing transfer between employers or personal plans.
- [ ] They are strictly non-portable.
- [ ] They are fixed to the initial workplace only.
- [ ] They cannot be transferred under any circumstances.
> **Explanation:** Most defined-contribution pension schemes allow the accumulated pension funds to be transferred if the individual changes jobs.
### Is the pension amount in a DC scheme fixed or variable?
- [ ] Fixed
- [x] Variable
- [ ] Governed by Social Security guidelines
- [ ] Set by corporate earnings
> **Explanation:** The pension amount in a defined-contribution scheme is variable, depending on the total contributions made and the investment returns.
### What happens to the contributions in a defined-contribution pension scheme?
- [x] They are invested in various financial products.
- [ ] They are held as cash by the employer.
- [ ] They are used to fund government projects.
- [ ] They are kept in a savings account.
> **Explanation:** Contributions in a defined-contribution pension scheme are typically invested in various financial products like stocks, bonds, and mutual funds.
### Which type of pension plan defines the benefit amount according to salary history and tenure?
- [ ] Defined-Contribution Pension Scheme
- [x] Defined-Benefit Pension Scheme
- [ ] 401(k) Plan
- [ ] Individual Retirement Account
> **Explanation:** Defined-Benefit Pension Schemes define the benefit amount according to salary history and years of service.
### What is a major risk for members of DC pension schemes?
- [ ] Guaranteed pensions regardless of contributions.
- [ ] Overestimation of required retirement age.
- [x] Investment performance risk.
- [ ] Excessive flexibility in contribution amounts.
> **Explanation:** A major risk for members of DC pension schemes is the investment performance risk since the final retirement benefits depend on how well the investments perform over time.
### How does taxation generally apply to DC pension schemes?
- [x] Contributions and investment growth often have tax advantages.
- [ ] There are no tax benefits.
- [ ] Contributions are always taxed at the highest rate.
- [ ] Taxation is more favorable for defined-benefit schemes.
> **Explanation:** Contributions and investment growth in defined-contribution pension schemes often have tax advantages, such as tax deferral on investment growth until withdrawal at retirement.
### In which of the following situations is a defined-contribution pension scheme most favorable?
- [ ] When aiming for a fixed retirement benefit regardless of investment performance.
- [x] When seeking flexibility in contributions and investment options.
- [ ] When working for an employer with no retirement benefits.
- [ ] When employed in a government job with predefined pension benefits.
> **Explanation:** A defined-contribution pension scheme is favorable when seeking flexibility in contributions and investment options and when retirement benefits depend on investment performance.
Thank you for exploring the intricacies of defined-contribution pension schemes and testing your knowledge with our targeted quiz. Continue to enhance your understanding of financial and retirement planning concepts!
