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The Defined-Contribution Plan

Money Manager | Monday, July 26th, 2010

Defined-contribution retirement plans are quite common, and have been increasing in popularity over the last couple of decades. As compared to a defined-benefit plan, where an employee is guaranteed a certain monetary amount on a regular basis for as long as they live after retirement, defined-contribution plans come with no such guarantee. Instead, set amounts of money are contributed to the plan over the course of a person’s career. At the point of retirement, the person has one lump sum of money, which they are then responsible for managing on their own.

What are some of the features of a defined-contribution plan?

Defined-contribution plans have become increasingly popular for a number of reasons. They are much easier and less expensive for companies to administer, and reduce much of the financial risk and uncertainty for employers. Employees usually also have the advantage of having some control in how the money in the defined-contribution plan is invested. Fixed contributions to the plan are made by the employer as well as the employee, and the funds are then invested in various ways to grow the money in the plan. Of course, there is also a chance that money may also be lost on the investments. More and more companies are decommissioning their defined-benefit plans in favor of offering defined-contribution plans. Examples of defined-contribution plans include the popular 401(k) plan, the 403(b) plan, and the 457 plan.

What are the advantages of a defined-contribution plan?

Many employees like the higher level of control that a defined-contribution plan provides. It is possible to choose from a variety of stocks, bonds, mutual funds and other kinds of investment options. These plans also provide employees with the opportunity to contribute larger amounts to their plan, as long as it is within the allowable range. These plans do not depend as much on the employee’s years of service, and instead can be heavily influenced by the performance of the plan’s assets. These plans are also much more portable if an employee changes jobs than a defined-benefit plan.

Are there any disadvantages to a defined-contribution plan?

Because there is no guarantee of regular payments for life after retirement, employees who do not save enough in their defined-contribution plan or who do not invest it wisely run the risk of running out of funds. Although some people do purchase annuities with their retirement savings, they are not required to do so, so there is always a risk of outliving your savings. These plans also require the employee to assume the risk for the performance of the investments that are utilized in the plan, since they have some choice in the matter. Although this level of control is often viewed as a good thing by those who are investment savvy, it can cause problems for those who are not sure concerning the best way to manage the funds in their account. Overall, defined-contribution plans are riskier for employees, especially if they do not save enough or if they are not sure how to manage and make the most of their funds before or after retirement.

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