Defined Contributions Plans

Definition

The term defined contributions plan refers to a pension plan consisting of a predetermined schedule of fixed employer contributions to an employee's fund.  With a defined contributions plan, the employer contributions are known ahead of time, and the exact retirement income benefit will depend on the performance of the investments in the employee's fund.

Explanation

Companies will provide employees with a pension plan as part of a larger array of employment benefits.  Pension plans are structured by companies to provide a periodic and reliable source of income when the employee reaches the plan's normal retirement age.  Generally, pension plans fall into one of the following two categories: defined benefits plans and defined contribution plans.

Since a defined contributions plan consists of employer contributions, it is considered an employer-sponsored retirement plan.  However, these plans may also allow employees to contribute to their fund.  Unlike a defined benefits plan, which provides the employee with a predetermined retirement benefit, a defined contributions plan provides the employee with a predetermined level of funding.  The contributions made by the employer are specified in the plan's documentation, and typically based on a combination of the employee's salary and age.

Unlike a defined benefits pension plan, the retirement income benefit derived from a defined contributions plan is a function of both the levels of funding as well as the performance of the fund's investments.  If the funds in a defined benefits plan underperform, the employer may have to increase their contributions to the pension fund.  If the funds in a defined contributions plan underperform, the employee will receive less retirement income.  Defined contributions plans are oftentimes criticized for shifting the risk and responsibility of underperforming investments from the financial experts in a company to its relatively inexperienced employees.

Related Terms

pension plan, defined benefit plan, multiemployer pension plan