Contribution Plans

With a defined-contribution plan (DCP), your employer contributes a specific amount to your retirement plan while you are working; then, when you retire, your employer is absolved of any further responsibilities. In a defined-contribution plan, both you and your employer generally contribute to the fund. Your pension is determined by how much both you and your employer invest each year, how fast the investment grows, and how many years your investment is able to grow.

Advantages and Disadvantages

The advantages of defined-contribution plans include that they have strong growth potential, they are portable, and they provide you with greater control. These plans are also tax advantaged in the sense that the contributions and earnings are tax-deferred money. The main disadvantage of these plans is that there is no guarantee as to the actual amount of money you will receive at retirement; in other words, defined-contribution plans shift the risk from your employer to you.

For employers, defined-contribution plans are advantageous because they are easier to manage, they have fewer government regulations, they provide a greater number of investment choices, and they come in many different types. The disadvantage to employers is that these plans take time and resources to manage.

Types of Defined-Contribution Plans

There are three different types of defined-contribution plans: discretionary (or optional) contribution plans, fixed contribution plans, and salary-reduction plans. In discretionary contribution plans, contributions are made at the discretion of the employer. In fixed contribution plans, contributions are fixed by the employer. And in salary-reduction plans, employees’ contributions are made on a before-tax basis.

There are three main types of discretionary contribution plans: profit-sharing plans, stock-bonus plans, and money-purchase plans.

In a profit-sharing plan, the employer’s contribution varies from year-to-year depending on the firm’s...