Defined Contribution Plans

The Basics of Defined Contribution PlansWhat is a defined contribution plan?
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 plans?
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 plans?
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 contribution plans?
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 contemplated?
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 choices.

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 portable.

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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 exist? 

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 profit-sharing provisions.

Q: What are some of the major attractions of defined contribution plans for employees? 

A:    Key attractions include:

• 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 benefit plans? 

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 participants. 

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 several factors:

• adverse market results,
• an inadequate rate of savings by the employee,
• poor investment fund selection or asset allocation by the employee, and/or
• a greater need for retirement assets than originally anticipated due to changing personal circumstances, or simply to a longer lifetime.

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 operating income.

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 risk. 

Q: How does participant control of investment decisions impact the employer? 

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 advice.

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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 Contribution Plans".

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 success.

Q: Beyond 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 U.S.? 

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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Q:  What is the size of assets held in defined contribution plans? 

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 2000.

The growth in private defined contribution plans has been significant in recent years, as summarized in the following tables:

Sources: EBRI, Bernstein  Research, CIEBA Surveys 

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 plan? 

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.

Q:  Why would an employer with an existing defined benefit plan choose a hybrid plan instead of a defined contribution plan if a change is contemplated? 

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. 

Q:  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.

Q:  What 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 well.

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