A defined contribution plan is a type of retirement plan in which the employer, employee, or both make contributions on a regular basis. In this plan, individual accounts are set up for participants, and benefits are based on the amounts credited to these accounts, as well as any income, expenses, gains and losses, and any forfeitures of accounts of other participants which may be allocated to such participants account.
In a defined contribution plan, contributions are paid into an individual account by employers and employees. The contributions are then invested, for example in the stock market, and the returns on the investment (which may be positive or negative) are credited to the individuals account. On retirement, the members account is used to provide retirement benefits, sometimes through the purchase of an annuity which then provides a regular income.
Defined contribution plans have become widespread all over the world in recent years and are now the dominant form of plan in the private sector in many countries. The most widely used type of employer-sponsored benefit plans in the United States are defined contribution plans. Some popular types of defined contribution plans are 401(k) and 403(b) plans.
Key differences between defined contribution plans and defined benefit plans include:
- In a defined contribution plan, both the employee and employer can contribute to the individual account, while in a defined benefit plan, generally only the employer contributes and the employee gets a monthly payout in retirement.
- Defined contribution plans offer no guarantees, and participation is voluntary and self-directed, while defined benefit plans guarantee retirement income and are computed using a formula that considers several factors, such as length of employment and salary history.
Overall, a defined contribution plan is a retirement plan that allows employees to allocate part of their paychecks to an account funding their retirements, and the employer may match a portion of employee contributions as an added benefit.
