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Explain Defined-Contribution Plans

With a defined-contribution plan (DCP), your employer contributes a specific amount to your retirement plan while you are working; then, when you retire, your employer is absolved of any further responsibilities. In a defined-contribution plan, both you and your employer generally contribute to the fund. Your pension is determined by how much both you and your employer invest each year, how fast the investment grows, and how many years your investment is able to grow.

Advantages and Disadvantages

The advantages of defined-contribution plans include that they have strong growth potential, they are portable, and they provide you with greater control. These plans are also tax advantaged in the sense that the contributions and earnings are tax-deferred money. The main disadvantage of these plans is that there is no guarantee as to the actual amount of money you will receive at retirement; in other words, defined-contribution plans shift the risk from your employer to you.

For employers, defined-contribution plans are advantageous because they are easier to manage, they have fewer government regulations, they provide a greater number of investment choices, and they come in many different types. The disadvantage to employers is that these plans take time and resources to manage.

Types of Defined-Contribution Plans

There are three different types of defined-contribution plans: discretionary (or optional) contribution plans, fixed contribution plans, and salary-reduction plans. In discretionary contribution plans, contributions are made at the discretion of the employer. In fixed contribution plans, contributions are fixed by the employer. And in salary-reduction plans, employees’ contributions are made on a before-tax basis.

There are three main types of discretionary contribution plans: profit-sharing plans, stock-bonus plans, and money-purchase plans.

In a profit-sharing plan, the employer’s contribution varies from year-to-year depending on the firm’s profitability. There may be no contributions made if the company has an unprofitable year.

Stock-bonus plans are profit-sharing plans in which employer contributions are made in the form of employer-owned shares of stock. Employee stock-ownership plans (ESOPs) and leveraged ESOPs (LESOPs) are the most common types of stock-bonus plans. In an employee stock-options plan, retirement funds are invested in company stock. This is a very risky and nondiversified plan because both your retirement and your job are dependent on the same company.  Since you are already an employee of the company, if the company does well, you will also likely do well, i.e., keep your job. If the company does poorly, you may lose your job, and also the value of your company stock is likely to decline as well. 

In a money-purchase plan, the employer contributes a percentage of the employee’s salary each year.

There are two main types of fixed contribution plans: thrift and savings plans and target-benefit plans.

In a thrift and savings plan, the employer matches a percentage of the employee’s contributions. These contributions are free money.

A target-benefit plan is a defined-contribution plan that has a required contribution level so that the employee will be able to meet a target level of benefits. Employers set this target level when an employee is hired, and the employer contributes to the plan each year to help the employee reach that level.

Finally, in salary-reduction plans, employees contribute before-tax dollars to invest for retirement. These contributions reduce the amount of the employees’ taxable income. These contributions remain tax-deferred until retirement. In salary-reduction plans, you can direct your funds into various investment options. Options include fixed-income securities, equities, money market funds, and guaranteed investment contracts (GICs).


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