What is a Defined-Contribution Plan?

A defined-contribution plan is a type of retirement plan in which both the employer and employee has specific responsibilities for when, how and what financial contributions must be made. Unlike a defined-benefit plan, where the employee can calculate exactly what his benefit will be upon retirement, with a defined-contribution plan there is no way of knowing. The size of the fund will depend heavily upon the size of the contributions made by the employee.

The final payout is determined by the amount of contributions made to the plan and returns on investments. The employer oversees the investments of the funds collected, although there are usually some limits as to where the employee can invest. Matching contributions made by the employer offers the employee incentive to invest as much as possible, even though there is generally a cap on how much the employer will match annually.

Defined contribution plans have specific rules which control the collection of contributions, but administering them is relatively simple. There are no complicated formulas for the employee to track and administrators mostly manage records following standard accounting practices. This simplicity makes such plans very appealing to both employers and employees.

Because there is no way to anticipate exactly what sort of payout will be available to the employee upon retirement, some companies have adopted a model that ensures that the employee will at least recoup the total amount they have contributed over the years. This payout is guaranteed even if the investments chosen didn’t perform as well as hoped.

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