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Defined Contribution Plan – Definition

Defined Contribution Plan Definition

It is a retirement benefit plan where the employees make a contribution each month until retirement to fund their retirement plans. For individual accounts set up for this plan, employees contribute a fixed percentage of their monthly salary to fund this account. The employers may also contribute a matching portion to this account in order to offer an attractive retirement benefits package to their employees.

A Little More on What is a Defined Contribution Plan

More than 75% of the companies in the U.S. contributes towards the pension account of the employees. Usually, the ratio of employee’s contribution and employer’s contribution is 2:1 up to a certain percentage. Some may pay even more depending on the terms of the benefit plan.

The retirement benefit is calculated on the credited amount in the account and investment earnings of that amount. As the investment earning varies with time, the benefit may also fluctuate. It is impossible to calculate the ultimate benefit amount the employees will get upon retirement.

Traditionally, the defined contribution plans have a tax-free contribution and taxable withdrawals. There are also defined contribution plans where the contribution amount is taxable, but the withdrawal is tax-deferred.

There are strict rules for the employees regarding withdrawing funds from these accounts. Defined contribution plan may also have certain provisions including automatic enrollment, automatic contribution hikes, hardship withdrawals, loan options and catch-up contributions for employees older than 50. These terms are defined by the nature of the plan.

References for Defined Contributions Plans

Academic Research on Defined Contribution Plan

Naive diversification strategies in defined contribution saving plans, Benartzi, S., & Thaler, R. H. (2001). American economic review91(1), 79-98. According to this research paper, a naïve diversification strategy was defined as a contributing factor in the saving plans. A worldwide trend towards the defined contribution saving plans and the growing interest in most private social security plan was also discussed in this paper. An investigation which accesses an aspect of the task “diversification” was also explained in this paper. Also, this paper indicates that several investors follow the “1/n strategy” and share their contributions equally across the funds offered in the plan.

Defined contribution pensions: Plan rules, participant choices, and the path of least resistance, Choi, J. J., Laibson, D., Madrian, B. C., & Metrick, A. (2002). Tax policy and the economy16, 67-113. This paper studies the impact on savings behaviour of several different 401(k) plan features which includes the automatic cash distributions, automatic enrollment, eligibility requirements, and financial education and investment options. Also, this paper presents new survey evidence on individual saving adequacy. In this paper, the analysis carried out points to a key behavioural principle that partially directs the design of 401(k) plans.

Defined benefit versus defined contribution pension plans: What are the real trade-offs? Bodie, Z., Marcus, A. J., & Merton, R. C. (1988). In Pensions in the US Economy (pp. 139-162). University of Chicago Press. In this study, some of the main tradeoffs involved in making choices between the DC and DB plans were studied in this paper. The conclusion drawn from this research indicates that neither of the aforementioned plan types can be said to exclusively dominate the other from the view of the employee’s welfare. It should be noted that the advantage of the DB plan is the capability they offer to provide a very consistent replacement rate of final income to workers. Finally, the DC plan has the advantage that workers can easily determine the exact present value of the pension benefits they earn annually.

The Behavior of Defined Contribution Plan Participants, Stabile, S. J. (2002). NYUL Rev.77, 71. This paper explains the behaviour of the defined contribution plan participants and how these contribution plans have helped to influence the firm’s income plans.

Stochastic lifestyling: Optimal dynamic asset allocation for defined contribution pension plans, Cairns, A. J., Blake, D., & Dowd, K. (2006). Journal of Economic Dynamics and Control30(5), 843-877. Investigations carried out in this paper show the various assess-allocation processes that are open to most members of the defined-contribution pension plans with which a model which includes salary (labour-income), assets and the interest-rate risk. This paper also explains several properties and characteristics of the optimal asset-allocation methodology both including and excluding the presence of the non-hedge-able salary risk. Also, according to t this paper, a comparison between the performance of the optimal strategy and some well-known alternatives adopted by pensioners were also examined.

Defined contribution pension plans: determinants of participation and contributions rates, Huberman, G., Iyengar, S. S., & Jiang, W. (2007). Journal of Financial Services Research31(1), 1-32. According to this study, a recorded data of about 793, 794 employees which were found to be eligible to partake of the 647 defined contribution pension plans were studied. The estimate carried out in this study indicates that 71% of the total eligible participants choose to partake in the plans; also, 12% chose to contribute the maximum allowed 10,500 USD. The most important factor to note according to this paper is that “the participation rate, savings rate and contribution increases with compensation on an average of 10, 000 USD all things being equal”. Also, participation rates are termed higher among low-income employees when the company stock is also the investable fund.

Toward explaining the growth of defined contribution plans, Ippolito, R. A. (1995). Industrial Relations: A Journal of Economy and Society34(1), 1-20. It is noted in this paper that the defined benefit plans have gradually lost its market share to the defined contribution plans. The defined contribution plans as of 1979 had 17% of the primary pension market and increased to 34% in 1988. This study, however, attributed this shift to loss of employment in giant unionized firms where the defined benefit plans are intensively utilized. In a nutshell, this paper explains the growth of the defined contribution plans.

Defined contribution plans, defined benefit plans, and the accumulation of retirement wealth, Poterba, J., Rauh, J., Venti, S., & Wise, D. (2007). Journal of public economics91(10), 2062-2086. According to this study, simulation of the distribution of retirement capital under the representative DC and DB plans was considered. This study adopts the use of data gotten from the HRS (Health and Retirement Studies) to explain earning histories, retirement plans properties and the asset returns contributes to the changes in retirement capital outcomes. Several possible asset allocation methodologies were considered, with most of the asset returns sketched from the historical return distribution. In this paper, the DB plans take its earning histories from the HRS and unsymmetrically assign each person a pension plan ascribed from a sample of large public and private defined benefit plans.

Own company stock in defined contribution pension plans: A takeover defence?, Rauh, J. D. (2006). Journal of Financial Economics81(2), 379-410. This paper believes that if managers stimulate employees to retain company stock in a defined contribution pension plan as a form of takeover defence, there are going to be imminent changes in the state laws that support managerial protection which will lead to a reduction in the rate at which employee stock in the 401(k) plan. Hence, the binary choice model which helps to attest that employee ownership in a defined contribution plans lowers the takeover chances. A takeover defence strategy was also explained in this study.

Determinants of couples’ defined contribution retirement funds, Yuh, Y., & DeVaney, S. A. (1996). Journal of Financial Counseling and Planning7, 31. In this paper, various factors associated with the number of defined contribution retirement funds by making use of the 1992 survey data of the Consumer Finances was discussed. Also, this paper notes that the funds increase as the years of employment and the employer’s contribution rate increases. However, most household having about 30 or more years from retirement had predicted their fund level as zero. In this study, the determinants of the couples’ defined contribution retirement funds were explained and how these funds could be raised was also discussed.

Pension substitution in the 1980s: Why the shift toward defined contribution?, Kruse, D. L. (1995). Industrial Relations: A Journal of Economy and Society34(2), 218-241. It should be noted that the relative decrease in the defined benefit pension plans and the increase in the defined contribution plans has been severally examined but not extensively investigated. This paper, however, is a comprehensive report on the construction of a reformed longitudinal company-based information sets regards the pension plans for the year 1980-1986 which includes all the United States companies with a bigger plan and a 10% sample of the company having small plans. According to the multi-nominal logit analysis of the manufacturing company, choices shows that an increase in the administrative cost of the DB plans will cause adopters to favour the Dc plans.

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