Defined-contribution
pension plans only define the amount of contribution the employer has to make to the plan. In
other words, the employer must only contribute a certain amount to the plan each
period. The amount of employer’s contribution is based on a formula, which
includes such factors as employee’s age, years of service, salary levels, and
employer’s revenues. Define-contribution plans, however, do not specify nor
make a promise about the benefits pension recipients (herein called employees),
covered by the plan, will ultimately receive in the future. Instead, the
employer hires an independent third-party trustee (i.e. pension trust) to
manage the employer’s contributions, to make investments, and to make
distributions to the beneficiaries of the plan (i.e. employees). Important to
note that the trust is an entity separate from the employer, and employees
are the only “beneficiaries” of the trust; that is, both
investment rewards (benefits) and risks (losses) are assumed by employees.
The
benefits an employee can receive under a defined-contribution plan depend on
the following factors:
- The
original amount of employer’s contribution
- Income
accumulated by the trust from its investments (e.g. in stocks, bonds)
- Forfeitures
of funds due to the early terminations of some employees
Some
defined-contribution plans offer additional benefits to employees. For
instance, under certain plans employers have to match a portion of the
employee’s contribution to the plan (i.e. employers have to contribute an
additional amount that equals a certain percentage of the employee’s
contribution). In such a case, employees usually cannot withdraw their funds,
without incurring a substantial penalty fee, until they reach a certain age
(e.g. 59.5 years).
In the
Unites States, the examples of defined-contribution plans are 401(k) plans,
403(b), and IRAs (Individual Retirement Account).
