R[^5^]https: www.fidelity.ca en insights articles defined benefit vs contribution

What Is a Defined Contribution Plan?

A defined contribution plan is a type of retirement plan in which an employer, employee, or both make regular contributions to an individual's account. Within the broader category of Retirement Planning, these plans differentiate themselves by the fact that the retirement benefit received by the employee depends directly on the amount contributed and the investment returns earned by the account over time. Unlike plans that promise a specific payout, the individual participant bears the investment portfolio risk and reward. Contributions are typically invested in various funds chosen by the employee, such as mutual funds, and grow on a tax-deferred basis until retirement. The popularity of the defined contribution plan has grown significantly as companies have shifted away from traditional pension structures.

History and Origin

The evolution of the defined contribution plan in the United States is closely tied to legislative changes in the late 20th century. While various forms of employee savings plans existed earlier, the modern defined contribution plan gained prominence with the passage of the Employee Retirement Income Security Act of 1974 (ERISA).⁵ This federal law established minimum standards for most private industry pension and health plans, aiming to protect the interests of plan participants and their beneficiaries. However, the most significant catalyst for the proliferation of defined contribution plans, particularly the 401(k), came with the Revenue Act of 1978.

This Act included a provision, Section 401(k) of the Internal Revenue Code, which allowed employees to elect to defer a portion of their income on a pre-tax basis. Initially intended to regulate deferred profit-sharing plans for executives, a benefits consultant named Ted Benna is widely credited with creatively interpreting this provision to design the first 401(k) salary reduction plan for his own company in 1981.⁴ This innovative application paved the way for the widespread adoption of such plans, eventually leading many companies to offer them in addition to, or in place of, traditional defined benefit plans.

Key Takeaways

A defined contribution plan's value at retirement depends on contributions and investment performance.
Participants bear the investment risk and reward, contrasting with employer-guaranteed payouts in other plan types.
Common examples include 401(k)s and 403(b)s.
Many plans allow for employer contributions, often in the form of matching employee contributions.
Funds in defined contribution plans typically grow on a tax deferral basis until withdrawal in retirement.

Formula and Calculation

While there isn't a single, universally applied "formula" for a defined contribution plan like there might be for a loan payment, the growth of a participant's account balance is fundamentally determined by a combination of contributions and investment returns. The projected future value of a defined contribution plan can be estimated using the principles of compound interest, where the current balance grows over time based on new contributions and the rate of return earned on the accumulated funds.

The account balance (A_t) at a future time (t) can be conceptualized as:

$A_t = \sum_{i=1}^{t} (C_i \times (1 + R)^{t-i}) + A_0 \times (1 + R)^t$

Where:

(A_t) = Account Balance at time (t)
(C_i) = Contributions made in period (i)
(R) = Annual investment rate of return
(t) = Number of periods (e.g., years)
(A_0) = Initial account balance

This formula illustrates that the total value is a sum of all individual contributions growing with investment returns, plus the growth of any initial balance. Factors like contribution limits set by regulatory bodies also influence the maximum amount that can be added annually.

Interpreting the Defined Contribution Plan

Interpreting a defined contribution plan involves understanding that the ultimate retirement benefit is variable and dependent on several factors that the individual controls or influences. The primary interpretation centers on the participant's direct responsibility for their retirement savings outcomes. This means understanding the impact of personal contribution rates, chosen asset allocation within the plan's investment options, and ongoing adjustments based on changing risk tolerance and market conditions. A higher contribution rate, consistent investing, and favorable market performance generally lead to a larger retirement nest egg. Conversely, insufficient contributions, poor investment choices, or significant market downturns can negatively impact the final account value.

Hypothetical Example

Consider an individual, Sarah, who starts a new job at age 25. Her employer offers a defined contribution plan (a 401(k)) and matches 50% of her contributions up to 6% of her salary. Sarah earns an annual salary of $60,000.

Sarah's Contribution: Sarah decides to contribute 10% of her salary, which is $6,000 per year ($500 per month).
Employer Match: Her employer contributes 50% of her 6% contribution limit, which is 3% of her salary, or $1,800 per year.
Total Annual Contribution: Together, Sarah and her employer contribute $7,800 to her defined contribution plan each year.
Investment Growth: Assuming an average annual return of 7% on her investments, her account balance will grow significantly over time. For example, after 10 years, even without considering the compounding within the year or salary increases, her contributions of $78,000 would have grown considerably more due to investment returns. This growth is a key benefit, enhanced by the power of diversification across various asset classes within her chosen funds. If Sarah continues this saving pattern until age 65, her total retirement savings could reach a substantial amount, primarily driven by compounded returns.

Practical Applications

Defined contribution plans are ubiquitous in modern Retirement Planning. They serve as the primary workplace retirement vehicle for millions of individuals, facilitating long-term wealth accumulation. A significant practical application is their use in facilitating access to diversified investments at generally declining costs, which has expanded retirement plan access for U.S. workers.³ These plans are widely used across various industries and company sizes, from large corporations to small businesses, offering flexibility in terms of investment choices and contribution levels.

Beyond basic savings, defined contribution plans play a critical role in withdrawal strategies during retirement, often allowing participants to manage their income through various distribution options, including lump sums, systematic withdrawals, or the purchase of annuities. The portability of these plans, allowing employees to roll over their accounts when changing jobs, is another key practical benefit. Furthermore, the shift to defined contribution plans has placed greater emphasis on financial literacy among employees, as they are tasked with making crucial decisions about their retirement investments.

Limitations and Criticisms

Despite their widespread adoption, defined contribution plans face several limitations and criticisms. A significant concern is the shifting of investment risk from the employer to the individual employee. Unlike traditional defined benefit plans, which guarantee a specific payout, the retirement income from a defined contribution plan is not guaranteed and can be significantly impacted by market performance and periods of high inflation. This places a considerable burden on individuals, who may lack the financial expertise to make optimal investment decisions.

Another criticism centers on the potential for inadequate savings. Many employees do not contribute enough to their defined contribution plans, and studies have shown concerns among plan sponsors regarding members' retirement income adequacy.² Furthermore, high fees, while generally decreasing, can still erode returns over time. The National Institute on Retirement Security highlights that the shift from defined benefit to defined contribution plans, particularly in the public sector, has led to increased costs and negative cash flow for employers, and has negatively impacted employee retirement security due to "leakage" of assets from accounts.¹ This underscores the challenge of ensuring sufficient retirement income in a system heavily reliant on individual savings and investment acumen. Issues surrounding vesting schedules and the absence of a strong fiduciary duty in some plans can also pose risks to participants.

Defined Contribution Plan vs. Defined Benefit Plan

The fundamental distinction between a defined contribution plan and a pension (or defined benefit plan) lies in who bears the investment risk and how the retirement benefit is determined.

Feature	Defined Contribution Plan	Defined Benefit Plan (Pension)
Benefit Defined	By contributions and investment performance.	By a formula (e.g., salary, years of service).
Risk Bearer	Employee (participant)	Employer
Contributions	Made by employee, employer, or both. Variable.	Primarily by employer. Actuarially determined.
Investment	Employee typically chooses investments.	Managed by the employer or plan administrator.
Payout	Varies based on account balance.	Predetermined, often a lifetime annuity.
Portability	Generally highly portable.	Less portable, often tied to single employer.

Confusion often arises because both are retirement plans, but their underlying mechanisms are opposite. In a defined contribution plan, the "contribution" is defined, but the "benefit" is not. In a defined benefit plan, the "benefit" is defined, but the "contribution" needed to fund it may vary. The shift from defined benefit plans to defined contribution plans has been a significant trend in private industry, moving the responsibility for retirement security from employers to individual workers.

FAQs

What are common types of defined contribution plans?

The most common types of defined contribution plans in the U.S. are 401(k) plans (for for-profit companies), 403(b) plans (for non-profit organizations and public schools), and 457 plans (for state and local government employees). Individual Retirement Accounts (IRAs) are also defined contribution accounts, though not typically employer-sponsored.

How are defined contribution plans taxed?

Contributions to traditional defined contribution plans are typically made on a pre-tax basis, meaning they reduce your taxable income in the year they are made. The investments grow tax-deferred. You only pay taxes on withdrawals in retirement, at your ordinary income tax rate. Roth versions of these plans (e.g., Roth 401(k)) allow after-tax contributions, with qualified withdrawals in retirement being tax-free. Understanding the implications for your overall tax deferral strategy is important.

Can I lose money in a defined contribution plan?

Yes, because the value of a defined contribution plan is tied to the performance of the underlying investments, you can lose money if your investments perform poorly. Unlike a pension, there is no guaranteed return or principal. This highlights the importance of understanding your risk tolerance and making informed investment decisions.

What happens to my defined contribution plan if I change jobs?

When you change jobs, you typically have several options for your defined contribution plan: leave the money in your former employer's plan (if allowed), roll it over into an IRA, roll it over into your new employer's plan, or cash it out (though this usually incurs taxes and penalties). Rolling over funds preserves their tax-deferred status and allows for continued growth.

How much should I contribute to a defined contribution plan?

Financial experts often recommend contributing at least enough to receive any available employer contributions (the "employer match"), as this is essentially free money. Beyond that, contributing as much as you can comfortably afford, up to the annual contribution limits set by the IRS, is generally advisable to maximize your retirement savings.