The Basics of Defined Contribution PlansWhat is a defined
What is a defined benefit plan?
What is the primary difference between a defined
contribution plan and a defined benefit plan?
What are some examples of defined contribution
What are some key reasons that defined
contribution plans exist?
What are some of the major attractions of defined
contribution plans for employees?
What risks are borne by participants in defined
contribution and defined benefit plans?
How does the risk to the employer differ with a
defined contribution plan vs. a defined benefit plan?
How does participant control of investment
decisions impact the employer?
What is the major plan design consideration
resulting from the regulation of defined contribution
Beyond financial considerations, what is the
burden of defined contribution plans on the employer?
How many participants are there in defined
contribution plans in the U.S.?
What is the size of assets held in defined
What are "hybrid" plans?
What is the difference between a cash balance
plan and a pension equity plan?
Why would an employer with an existing defined
benefit plan choose a hybrid plan instead of a definedcontribution plan if a change is
What is an ESOP?
What is an ERISA Section 404(c) plan?
Q: What is a
defined contribution plan?
A: A defined contribution plan
is a retirement savings vehicle that provides benefits "defined" by
the contributions to the plan and the investment earnings on those
contributions. These contributions and subsequent earnings
are credited to an individual account for each participant.
The amount owed to participants at retirement is based solely on
their account balances at the time of withdrawal. In these
plans participants often bear responsibility for managing the
investments of their account. They may need to choose among a
few or many investment options that are offered by the employer
(plan sponsor). The investment earnings that a participant
accumulates are directly related to that participant's investment
Q: What is a
defined benefit plan?
A: In a defined benefit plan,
the benefit payment for each participant is calculated ("defined")
by a formula specified in the plan. The formula is most often
based on factors such as level of pay and length of service.
The projected future benefit payments for all participants are then
aggregated and discounted to obtain the present value of the plan's
liability, also sometimes referred to as the
plan's obligation. That liability or
obligation is funded by employer contributions (and sometimes
employee contributions) and their cumulative earnings. The
value of the assets is measured independently of the liability and
is based on fair market value. A defined benefit plan can
thus be overfunded or underfunded, depending on whether the value
of the plan's assets is greater than or less than the amount of the
liability. In contrast, in a defined contribution plan the asset
and the liability are by definition always equal in value.
Q: What is the
primary difference between a defined contribution plan and a
defined benefit plan?
A: The primary difference
between defined benefit and defined contribution plans lies in who
bears the risk of a shortfall in investment results. This
risk accrues to the employer in the case of
defined benefit plans. It is borne by the
employee in the case of defined contribution
plans, although commensurately, the employee also receives all the
benefits of better than expected investment performance.
In other words, a typical defined benefit plan promises a
benefit upon retirement linked to pay and years of service.
If contributions and investment earnings on the contributions do
not provide enough funds to meet that promise at retirement, then
the employer must make additional contributions to meet the
shortfall. If investment earnings exceed expectations, then
the employee still receives only the promised benefit. In
defined contribution plans, on the other hand, higher than expected
investment returns are passed on directly to the employee, who,
however, must also accept the risk of a lower asset value if
returns are disappointing.
Other important differences include the fact that in the early
years of an employee's career account values in defined
contribution plans generally grow faster than in defined benefit
plans (but generally grow more slowly in later years).
Additionally, defined contribution plan assets are generally more
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Q: What are some
examples of defined contribution plans?
A: The most prominent type of
defined contribution plan is the 401(k). The
401(k) feature of a savings plan permits deferral of taxes on
employee contributions. The term "401(k)" refers to Section
401(k) of the Internal Revenue Code (IRC) of 1986, as
amended. Profit-sharing plans may also have
a 401(k) feature, as long as the profit-sharing contribution does
not exceed a stated maximum percentage of pay.
Employee Stock Ownership Plans (ESOPs), which are
also defined contribution plans, are designed to invest primarily
in employer securities.
Q: What are some
key reasons that defined contribution plans
A: Defined contribution plans
foster long-term savings behavior among employees. In some
firms, a defined contribution plan is offered alongside a defined
benefit plan as a complementary benefit. In fact, employers
often use defined contribution plans as a workforce recruitment and
retention method. The defined contribution plans can in some
cases provide a vehicle for large-scale employee ownership of
company stock (e.g., ESOPs) by offering employees the opportunity
to invest in the common stock of the employer as one of several
investment choices. Finally, most defined contribution plans
create a link between the assets of the employee and the success of
the employer through the latter's matching of all or part of each
employee's contributions. In some cases, the link is made
particularly strong by setting the level of employer contributions
as a function of company profitability, such as in plans with
Q: What are some of the
major attractions of defined contribution plans for
A: Key attractions
- In most defined contribution plans, the account value grows
faster in the early years of employment than the benefit in a
traditional defined benefit plan.
- Defined contribution plans have a portability or lump-sum
feature, which allows employees to take this benefit with them if
they leave their current employer.
- Deferral of taxes on employee contributions and/or earnings,
along with deductibility of employer contributions, provides a
financial incentive for both the participant and the employer.
- The value of the average defined contribution plan tends to be
more easily understood by employees and is more visible to them
than is the value of a traditional defined benefit plan.
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Q: What risks
are borne by participants in defined contribution and defined
A: As discussed above, in
defined contribution plans that are
participant-directed - where the participant is responsible for
deciding how individual account assets are invested among a plan's
available investment options - investment risk is transferred to
the participant. This, combined with the need to implement a
realistic, adequate savings plan, are key concerns for
In a defined contribution plan mortality risk is also
transferred to the participant. Mortality risk is the risk
that the participant may live longer than average, and thus outlive
their retirement assets. In participant-directed plans, the
employee has more control over the building of retirement assets,
through the selection of investments and the ability to direct a
portion of his or her pay to the plan. However, participants
have few avenues of recourse should their accumulated assets turn
out to be insufficient for their retirement needs.
Thus, insufficiency of retirement assets can be ascribed to
- adverse market results,
- an inadequate rate of savings by the employee,
- poor investment fund selection or asset allocation by the
- a greater need for retirement assets than originally
anticipated due to changing personal circumstances, or simply to a
In a defined benefit plan, on the other hand,
the employer is generally responsible for bearing both investment
risk and mortality risk, although the situation differs somewhat
with defined benefit "cash balance" plans (see below under "Hybrid
Plans"). An additional level of security is provided for
employees by the Pension Benefit Guaranty Corporation (PBGC), a
U.S. government agency that insures the pension plans of private
U.S. corporations; nevertheless, in the event the company does not
fulfill its obligations, some residual risk of insufficiency is
also borne by the participants who are owed larger pensions, to the
extent that the PBGC may not cover 100% of the promised
benefit. For most employees, however, this risk is generally
considered to be small.
As well, a portion of the defined benefit owed to a higher-paid
employee may exceed the maximum allowable limit that can be paid
out of an ERISA-qualified plan (see below under "Regulation of
Defined Contribution Plans" for a discussion of the Employee
Retirement Income Security Act, or ERISA), and thus for that
higher-paid employee, the excess benefit does bear long-term
corporate credit risk.
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Q: How does
the risk to the employer differ with a defined contribution plan
vs. a defined benefit plan?
A: The employer's reported
expense for a defined contribution plan is closely aligned with
employer contributions. This is an attractive feature for
employers, since in most cases, the amount of employer
contributions is far less volatile than potential employer
contributions to defined benefit plans, which are affected by
current interest rates, actuarial assumptions and investment
performance. The affect of these factors on defined benefit
plan assets can contribute to volatility in the employer's
On the other hand, the potential opportunity to reduce employer
contributions is generally available only in defined benefit
plans. If the value of the assets in a defined benefit plan
is greater than the promised payments to participants, the required
employer contributions may decrease over time. This
opportunity to decrease the level of contributions does not
generally exist in a defined contribution plan, as contributions
are set by a specified plan formula such as a "company match" and
are not related to the value of the assets.
Finally, as stated above, the transfer of investment risk and
mortality risk to participants also serves to reduce the employer's
Q: How does
participant control of investment decisions impact the
A: Most, but not all, defined
contribution plans are participant-directed. The successful
use of a participant-directed defined contribution plan usually
requires employers to inform and educate plan participants.
The majority of employees need substantial education in order to
effectively manage investment and mortality risk. It is
important that the employer equip participants to make long-term
investment decisions in market environments that can be
characterized by unsettling fluctuations. However, in
designing a financial education program for defined contribution
plan participants employers must give careful consideration in
order to avoid liabilities associated with offering investment
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Q: What is the
major plan design consideration resulting from the regulation of
defined contribution plans?
A: In order to remain qualified
for favorable tax treatment of contributions and earnings, a
defined contribution plan must clear a demanding array of
nondiscrimination test rules. These tests are designed to
ensure the plan does not discriminate in favor of highly paid
individuals. The ability to pass these tests generally
improves as the participation rate of non-highly compensated
employees increases. Nondiscrimination tests are discussed
further under the section entitled "Regulation of Defined
Thus designing a plan that will be attractive to the majority of
the workforce is perhaps the most important factor arising from the
regulations. There may be a large difference, however,
between designing such a plan and actually persuading less-highly
compensated employees, who are sometimes pressed to pay for
ordinary living expenses, to participate. Effective education
programs that explain the value gained from tax deferral and
employer-matching programs are often critical to the plan's
financial considerations, what is the burden of defined
contribution plans on the employer?
A: The breadth and complexity of
compliance testing requirements are discussed under "Regulation of
Defined Contribution Plans" below. Attractive investment
options and effective participant communication are crucial to
encouraging employees to participate. Thus communication,
education and investment oversight responsibilities constitute
meaningful fiduciary burdens. Investment oversight can become
increasingly onerous as investment options are added in the effort
to attract and sustain employee interest. Employers are also
faced with additional administrative issues involving maintaining
records for participant accounts, identifying cost components and
reviewing trustee accounting records.
Q: How many
participants are there in defined contribution plans in the
A: There were an estimated 53
million participants in private sector defined contribution plans
in 1999. In defined contributions plans sponsored by 117
CIEBA members, the number of participants was approximately 6.1
million in 2000.
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is the size of assets held in defined contribution
A: Assets held in private sector
plans in 1999 totaled $2,126 billion. In defined contribution
plans sponsored by CIEBA members, assets totaled $509 billion in
The growth in private defined contribution plans has been
significant in recent years, as summarized in the following
Total Private Sector
Number of Participants:
Percent of U.S. Workforce Covered:
Number of Plans:
Number of Participants
Sources: EBRI, Bernstein Research, CIEBA
Q: What are "hybrid" plans?
A: Legally, every plan is either
a defined benefit plan or a defined contribution plan, regardless
of what its various characteristics may look like to the
participant. However, hybrid plans have been developed that
offer various blends of defined benefit and defined contribution
characteristics. The increasingly popular cash balance plan,
for example, often has a portability feature and reports
participant "balances" that look just like defined contribution
accounts. However, cash balance plans are actually defined
benefit plans. Similarly, pension equity
plans, (also known as retirement bonus plans) report account
balances to participants and look like defined contribution plans
but are also in reality defined benefit plans.
In both cash balance and pension equity plans, the "accounts"
reported to participants are their actual balances, but these
balances are not in any way impacted by actual investment
results. The value of the "accounts" in each case is
determined by an established formula rather than by a variable
investment return. This qualifies the plans as defined
benefit structures, but lessens the employer's exposure to
investment risk, as well as to mortality risk.
Other examples of hybrid plans include various "floor" plans,
which are actually two coordinated plans, one of which is a defined
benefit plan and the other a defined contribution type. The
defined benefit plan normally sets a floor retirement
payment. Investments in the defined contribution plan will
determine the retirement payment if its value exceeds the value of
the floor payment. If the value of the defined contribution
account drops below the floor, the defined benefit plan funds the
gap and the participant receives the floor payment.
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Q: What is
the difference between a cash balance plan and a pension equity
A: The basic difference between
the two types of plans is that the cash balance plan is a
career average plan and the pension equity design
is a final pay plan. In a cash balance plan
benefits increase by a rate applied to eligible compensation for
each year of employment, without consideration of future
inflation. In a pension equity plan a rate is applied to
average final compensation, which generally incorporates the effect
of inflation over the service period. The equity plan rate is
a cumulative rate based on age and/or years of service.
would an employer with an existing defined benefit plan choose a
hybrid plan instead of a defined contribution plan if a change is
A: When an employer decides to
change from a traditional defined benefit plan to a plan with
defined contribution characteristics, converting to a hybrid plan
may be the preferred alternative. A hybrid plan may be the
more attractive choice if the existing defined benefit plan is
substantially overfunded. Redesigning the existing plan as a
hybrid allows the surplus assets in the plan to continue to prefund
employer contributions, thus controlling costs more effectively
than a plan termination would allow. The employer may also
prefer to retain control of investment decisions in the plan.
The employer may use a hybrid plan design to improve the
workforce recruitment and retention power of the existing plan by
giving it some user-friendly defined contribution-like
characteristics, such as "account" balance reporting and
portability. Portability may have additional usefulness to
the employer, since it helps to control the size of the plan
liability by paying it out more rapidly.
What is an ESOP?
A: An Employee Stock Ownership
Plan (ESOP) is a defined contribution plan that is required by law
to invest primarily in the securities of the sponsoring
employer. An ESOP is a trust to which an employer makes
tax-deductible contributions. These contributions can either
be in cash (which is then used by the ESOP to buy employer stock)
or directly in the form of company shares. These
contributions are allocated to individual employee accounts within
the trust based upon a specified formula. A key motivation
for setting up one of these plans is to broaden the ownership of a
company's capital to align employer and employee interests.
is an ERISA Section 404(c) plan?
A: An ERISA 404(c) plan is one
"which provides for individual accounts and permits a participant
or beneficiary to exercise control over assets in his
account". The plan sponsor remains a fiduciary for the
purpose of manager selection for any investment option offered, but
is not considered a fiduciary in the case of a participant's
selection of one investment option over another. 401(k) plans
generally meet requirements of Section 404(c), however, the 404(c)
definition is wider, encompassing certain non-401(k) plans as
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