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Defined-Contribution Plan

A type of pension fund to which an employee and/or an employer contribute based on terms agreed to by both parties

What is a Defined-Contribution Plan?

A defined-contribution plan (also known as a DC plan) is a type of pension fund payment plan to which an employee, and sometimes an employer, make regularly occurring contributions.

 

Defined-Contribution Plan

 

Each employee maintains an individual pension account and is entitled to the contributions made (by the employee and, if applicable, the employer) plus any investment earnings made from the contributions.

 

Summary

  • The defined-contribution plan is a type of pension fund to which an employee and/or an employer contribute based on terms agreed to by both parties.
  • The employee decides how the pension funds are to be invested and also bears the risk of loss due to poor investments.
  • The defined-contribution plan is becoming commonplace in many countries across the world.

 

Defined Terms of Contribution

The level of contribution varies among different employment contracts. Depending on the specific employment terms, the defined-contribution plan can include the employee and/or the employer making recurring payments.

Most frequently, a contract will include either the employee and the employer or only the employee making contributions – usually in the form of employee salary deferrals – to the pension. It is rare for contracts to designate the employer alone to make the contributions.

In recent years, the defined-contribution plan has become the dominant form of pension plan in many countries.

 

Investment of Funds

The fixed contributions that are paid to the pension fund are, in turn, invested – e.g., into the stock market– and the returns are added to the employee’s pension.

It’s important to note that the results of the investment are exacted upon the employee, whether it is a gain or a loss. That is, the employee who is the beneficiary of the defined-contribution plan assumes the potential gain, as well as the risk of the investments.

Such a risk is the key difference between a defined-contribution plan and a defined-benefit plan. The former involves risk, while the latter promises a predetermined pension amount.

 

Defined-Contribution Plans in the United States

In the United States, a defined-contribution plan is defined as “a plan providing for an individual account for each participant, and for benefits based solely on the amount contributed to the account, plus or minus income, gains, expenses, and losses allocated to the account.”

In essence, the statement is equivalent to the general definition – an employee is entitled to the “amount contributed” alongside the gains or losses from investments.

 

Thrift Savings Plan (TSP)

The Thrift Savings Plan (TSP) is an example of a defined-contribution plan for current and retired U.S. civil service employees and members of the uniformed services.

It is the largest defined-contribution plan in the world, with approximately 5.5 million participants and managing $558 billion in assets, as of December 31, 2018.

 

Employer Contributions

For most employees enrolled in the TSP, the employers contribute in the following fashion:

  • $1 for the first 4% of base pay
  • $0.50 per $1 for the next percent of base pay (i.e., up to 5%)
  • Amounts above 5% are not matched by the employer

 

Investment Choices

Overall, the TSP provides civil employees ten funds in which they can invest. Five of them are target-date funds (also known as lifecycle funds), and five are individual funds. The five target-date funds are:

  • L2050 (retirement date of 2045 and thereafter)
  • L2040 (retirement date between 2035 and 2044)
  • L2030 (retirement date between 2025 and 2034)
  • L2020 (retirement date between 2015 and 2024)
  • L Income (individuals currently receiving monthly payments)

 

The five individual funds are:

  • The G fund (government securities fund)
  • The F fund (fixed income index fund)
  • The C fund (common stock index fund)
  • The S fund (small-cap stock index fund)
  • The I fund (international stock index fund)

 

Employees who are enrolled in the TSP can choose any or all of the target-date or individual funds in which to invest and are allowed to change the investment allocations for future payments at any time.

Specifically, any fund other than the G fund carries a risk for a loss of principal, which the employee chooses to bear when investing in such a fund.

 

Other Countries that Employ Defined-Contribution Plans

Defined-contribution pension plans for employees are quickly becoming popular. Some countries that now frequently provide DC plans include:

  • The United Kingdom
  • Japan
  • Singapore
  • India
  • France
  • Italy
  • Spain

 

Additional Resources

CFI is the official provider of the global Certified Banking & Credit Analyst (CBCA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional CFI resources below will be useful:

  • 401(k) Plan
  • Money Purchase Pension Plan
  • Vesting Schedule
  • Variable-Benefit Plan

Financial Analyst Certification

Become a certified Financial Modeling and Valuation Analyst (FMVA)® by completing CFI’s online financial modeling classes and training program!