Defined Contribution Plans

Saving For Retirement With Defined Contribution PlansWhat are before and after-tax savings?
How do defined contribution plans grow over time to provide benefits to participants upon retirement?
How are employee contribution limits set?
What are the withdrawal provisions in a 401(k) plan?
How do loan and withdrawal provisions impact the risk to the participants?
What types of investment options are typically offered in a defined contribution savings plan?
What are the costs to participants of defined contribution plans?
What are 12b-1 fees?
What are redemption fees?
On average, how have plan participants allocated their defined contribution plan investments?
How should participants allocate their assets? 

Q:  What are before and after-tax savings? 

A:  As mentioned, the most frequently sponsored defined contribution plan is the 401(k) plan.  Participants can defer federal income taxes and, in most cases, state and municipal income taxes on their qualified pre-tax contributions to these plans.  Participants can also defer taxes on earnings on those contributions until they withdraw money from the plan.  The employer plays an important role in promoting financially secure retirements for participants by communicating the value of tax deferral on both qualified contributions and earnings.

Many plans also allow after-tax savings.  Although after-tax contributions do not reduce the participant's taxable income, earnings on those contributions are generally not taxed until the participant withdraws them. 

Plans generally provide flexibility when it comes to allocating between the two.  In some cases, a plan offering both before and after-tax contributions will automatically convert the employee's before-tax contributions to after-tax when the before-tax contribution limits (see below under "Regulation of Defined Contribution Plans") are breached.  Others require explicit instructions from the participant.

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Q:  How do defined contribution plans grow over time to provide benefits to participants upon retirement? 

A:  Generally, as employee and employer contributions in 401(k) and similar defined contribution plans are invested, earnings compound on a tax-deferred basis until assets are withdrawn.  These plans are designed to grow in value over the career of the participant, although provisions are available to allow some access to the assets as well as early withdrawal under certain circumstances.  The amount that will be available to the employee upon retirement is determined by:

Earnings on investments are reinvested and additional contributions can be made on a regular schedule.  Therefore, the value of a defined contribution account can grow substantially over time.  Below are some examples of the value at retirement of different contribution levels over different time periods, assuming an 8% annual return, on average, over the time period:

By contribution through payroll deduction, participants typically invest a fixed amount with each paycheck.  Investing a fixed amount on a set timetable has the effect of dollar-cost averaging investments in the market, a method that may help to enhance investment results over the long-term.  Dollar-cost averaging means that an investor can buy more shares of an asset when market prices are low, and conversely buys fewer shares of the same asset when market prices are high, given the same dollar amount available each period for investment.

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Q:  How are employee contribution limits set? 

A:  The Internal Revenue Service (IRS) limits the amount a participant can contribute before taxes to 401(k) plans to a maximum dollar amount subject to special non-discrimination tests.  The amount an employee can contribute after tax is also subject to certain limitations. A more complete discussion is contained below in the section entitled "Regulation of Defined Contribution Plans".

Until recently, a tax-qualified retirement plan could not include an IRA.  However, under the tax legislation passed in 2001 such plans (e.g., 401(k) plans) are permitted to accept voluntary employee contributions to a separate account that (1) is established under the tax-qualified arrangement, and (2) meets the requirements for a traditional IRA.  These accounts would be deemed IRAs and the IRA rules would apply, effective for plan years beginning after 2002.  Furthermore, after 2005 employers may allow employees to make "Roth" contributions to 401(k) plans.  An employee would contribute after-tax dollars, but, as with Roth IRAs, both contributions and earnings generally would not be subject to tax upon distribution from the plan.

Q:  What are the withdrawal provisions in a 401(k) plan? 

A:  A participant or beneficiary can withdraw assets upon the participant's retirement, death, disability or separation of service.  Subject to a plan's design, participants can take their money in the form of a lump sum distribution, including rolling the money into another qualified retirement plan or an Individual Retirement Account (IRA).  Plans may allow participants to leave some, or all, of their money in their employer's plan.  Some plans also offer lifetime annuities or the ability to make periodic withdrawals from the account.  If they have retired from the employer, participants must begin to withdraw their assets by April 1 following the calendar year during which they attain age 70 �.

Should an employee need assets before retirement, the regulations allow plans to incorporate two methods for participants to access their balances:

Some plans allow "in-service" withdrawals, whereby an annual withdrawal of after-tax monies and vested company contributions can be made without penalty.

Plan assets are generally portable, meaning that individuals who leave an employer may be permitted to transfer their plan assets to a new employer's qualified plan, or to roll their assets into an IRA.  Thus, plan participants who do not work for the same employer for their entire careers are still able to save and invest for retirement without proliferating plans and investment vehicles.

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Q:  How do loan and withdrawal provisions impact the risk to the participants? 

A:  As discussed, the loan, hardship and (in some cases) in-service withdrawal provisions of defined contribution plans give the participant flexibility to adapt to changing circumstances.  Certainly most participants would view the availability of loans and withdrawals as reducing their short-term risk.  What they may not fully appreciate, however, is that these provisions may very well increase their long-term risk rather than reduce it.  Despite loan provisions requiring systematic repayment (without which many participants might simply withdraw funds) overuse of the loan feature naturally reduces the compounded growth of assets in a participant's account.  Also, as the loan repayment is made with after-tax dollars, this can effectively result in double taxation when taxes are paid on future withdrawals (in other words, the loan is repaid with monies that have been taxed once, usually as income, and these monies then are subject to tax once again when later withdrawn from the plan during retirement).  Moreover, failure to comply with loan terms can result in penalties for the participant.

As an aside, long-term risk for the participant may be reduced by the portability of defined contribution assets, since many defined contribution plans accept rollovers from other qualified plans, thereby reducing forfeitures.  A lower incidence of forfeitures improves the likelihood of sufficient assets being accumulated for retirement by participants with relatively low balances.

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Q:  What types of investment options are typically offered in a defined contribution savings plan? 

A:  Defined contribution plans can offer a variety of investment options.  The structures used for investment options can be comprised of an assortment of mutual funds, commingled trust accounts, and/or separately managed accounts.  A mutual fund pools the money of many individuals to invest in specific types of assets.  Trust accounts, such as bank pooled funds, which are exempted from SEC registration by the Investment Advisors Act of 1940, and Group Trusts, are similar to mutual funds but are restricted to IRS qualified benefit plans.  Separate accounts can contain only assets of the sponsor's plan and are not available to other, outside investors. 

Any of these structures can be used to provide an array of investment options. Examples of options that appear in many plans include:

• Money market funds - Invest in short-term securities and earn an interest rate equivalent to currently prevailing rates.  It is unlikely that the value of these funds will fluctuate significantly, but the interest earned is usually low relative to more risky investments.
• Stable value funds - Invest in fixed annuity or guaranteed investment contracts issued by insurance companies, banks, or other financial institutions.  The issuing company pays a rate of interest that it guarantees over some period.  While the rate of interest is guaranteed, the credit risk of the contract depends on the creditworthiness of the issuing insurance company or other financial institution and sometimes on any bonds or other assets held in a separate account for the specific purpose of backing the contract. 
• Bond funds - Invest in debt securities issued by corporations or governments.  Some bond funds invest in specific types of bonds, for example, just government securities or corporate securities of specific quality. These funds may also target an average maturity or duration for the portfolio.  Bond fund prices fluctuate with changes in interest rates.  However, these changes in value are typically not as volatile as those of equity funds.
• U.S. Equity funds - Invest primarily in domestic stocks.  The investment goals and guidelines of such funds can vary widely, as they are often structured to invest in a specific segment of the market.  For example, an equity fund may invest primarily in large capitalization stocks, small capitalization stocks, growth stocks or value stocks.  Actively managed funds seek to earn higher returns than the market index that most closely defines the investment management style of the fund.  Indexed equity funds seek to replicate the performance of a particular market index.
• Balanced funds - Invest in a combination of equities and bonds.  Some plans offer several balanced funds (often referred to as lifestyle, time-horizon or asset allocation funds) that offer different levels of expected risk and return. 
• International funds - Invest in securities issued by companies and governments outside of the United States.  International funds may invest primarily in equities, primarily in bonds, or in a combination (international balanced) of stocks and bonds.  Global funds invest all over the world including the United States.  International and global funds may also invest in specific segments of the market and may be actively managed or indexed to a market index.
• Company stock - Many employers include a company stock fund as an investment option.  Company stock funds offer employees tax-favored participation in the earnings and growth of their company.

Q:  What are the costs to participants of defined contribution plans? 

A:  The fees associated with defined contribution plans fall into two main categories - investment management fees and administration fees.  Investment management fees, typically the largest cost component of a fund, are usually charged as a percentage of assets under management.  In the case of non-mutual fund investment vehicles the percentage charged sometimes declines as the asset base increases.  However, investment management fees charged by mutual funds are usually a set rate regardless of the amount of invested assets. 

Investment fees vary by investment type.  For example, money market funds, which offer low risk and return, generally have lower fees than stock funds.  Actively managed funds have higher fees than index funds.

The cost of trading securities (broker commission and trade execution) is reflected in the reported value of the fund.  Investment returns are reported net of all trading costs and, in the case of mutual funds, net of all investment management fees.

Administration fees (internal and external) include the cost of recordkeeping, trustee and custodial services, and of communications to participants.  Some mutual funds also charge sales commissions, although this charge is usually waived for defined contribution plans.  Mutual funds may also charge 12b-1 distribution fees and redemption fees.   Although these fees are sometimes shown on the participant's statement, some or all administration charges may also be deducted directly from reported returns.

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Q:  What are 12b-1 fees? 

A:  The 1980 U.S. Securities and Exchange Commission Rule 12b-1 (under the Investment Company Act of 1940) permits mutual funds to charge certain distribution-related expenses directly against fund assets.  These charges may include fund administration charges, communications charges or promotional charges.  Some mutual funds reimburse pension plans for 12b-1 fees, and sometimes for a portion of the funds' administrative charges.

Q:  What are redemption fees? 

A:  Redemption fees, sometimes referred to as short-term trading fees, are charged to a participant's account if the shares of the mutual fund are held less than a specified period of time.  The fee is assessed to discourage short-term trading in a fund, which can have a negative effect on the mutual fund's performance.  The fee, deposited in the fund, helps offset trading costs that would otherwise be borne by the remaining fund participants.

Q:  On average, how have plan participants allocated their defined contribution plan investments? 

A:  Participants in CIEBA member plans made the following investment selections in recent years:

Source: CIEBA Surveys, 1994 and 2000

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Q:  How should participants allocate their assets? 

A:  Participants should base their allocation decisions on their individual savings situation, risk, and potential investment returns.  Determining savings requirements and risk tolerance means that participants have to develop expectations regarding:

Investment education is important to help employees estimate their savings and risk requirements.

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