Saving For Retirement With Defined Contribution
PlansWhat are before and
How do defined contribution plans grow over time to
provide benefits to participants upon retirement?
How are employee contribution limits
What are the withdrawal provisions in a 401(k)
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
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
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assets are withdrawn.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:
1)The total contributions to the plan,
2)The number of years that an employee participated in the plan,
3)The amount earned on those contributions.
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:
Number of Years
Value at Retirement
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:
- Loan provisions - Loans permit individuals to
borrow from their accounts, but they must repay the loan with
interest at market rates in order to maintain the tax-deferred
status of their accounts.
- Hardship withdrawals - Financial hardships in
accordance with the Internal Revenue Code (IRC) include payment of
college tuition for participants or their dependents, purchase of a
primary residence, prevention of a foreclosure or eviction from a
primary residence and coverage of unreimbursed medical
expenses. Any such withdrawals are, however, taxable.
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
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Q: How do loan
and withdrawal provisions impact the risk to the
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
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Q: What types of
investment options are typically offered in a defined contribution
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
- 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
- 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
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
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
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Q: What are
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'
Q: What are
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
A: Participants in CIEBA member
plans made the following investment selections in recent years:
% of Assets Invested in CIEBA Member Plans
Other Fixed Income
Source: CIEBA Surveys, 1994 and 2000
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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:
- Market returns and the rate of inflation
- Their personal tolerance for market variability
- The time they will participate in the plan
- Financial needs that might require loans/withdrawals (e.g.,
- The amount they will contribute, and the amount their employer
will contribute on their behalf
- Their spending plans after retirement
- The number of years they will be retired
Investment education is important to help employees estimate
their savings and risk requirements.
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