Defined contribution and savings plans

How defined contribution accounts work

Defined contribution retirement plans are different from traditional defined benefit plans. In defined contribution plans, the worker or the company contribute a set amount to a tax sheltered retirement account.

One worker's money is not pooled with another's money, and generally the individual can manage the assets in her account. The initial investment in the account is defined, but the ultimate value of the account at retirement is unknown.

With traditional defined benefit plans the employer says, "Don't worry. We'll take care of you at retirement by giving you a known amount of money each month." These plans don't require the worker to do anything, but the worker has to hope that the employer lives up to the promise.

With today's defined contribution savings plans, the employer says, "Here's some money to match what you've saved on your own. I hope it grows into a good nest egg." Now the worker has the responsibility of managing the money, but doesn't have to rely on the trustworthiness of the employer.

Advantages of defined benefit programs

As you can see, today's defined contribution plans shift responsibility to workers, and this may wind up being a good thing. Although the vast majority of traditional pension plans are well run, I've seen plenty of cases where workers were cheated.

The plan is either raided by management or union bosses, or a worker is fired just before they qualify for benefits. I think it may be better to have your money, in your account, under your management than to count on someone else's promises.

Types of defined contribution accounts

When it comes to defined contribution accounts, there are a number of different types. And actually I think it's better to call these defined contribution and savings plans because the worker contributes the most through payroll savings, while the employer only contributes a matching amount in some cases.

The most prevalent are 401(k) accounts which generally apply to workers in for-profit corporations. Another popular plan is the 403(b) account which is for nonprofit workers like teachers or hospital employees. Nonprofit organizations used to be limited to 403(b) plans, but recent tax law changes have opened up 401(k) accounts to nonprofits as well.

State and local workers can use 457 plans, while federal government employees can utilize the Federal Thrift Savings Plan.

Copyright 1997 by David Luhman