A defined contribution plan is a retirement or pension plan that specifies the responsibilities of both the employer and the employee regarding how, when, and what amount of financial contributions may be made to the plan. Generally, the benefits received by the employee after retirement are determined by the amount of contributions made to the plan and any returns from investments that are conducted using the contributions. For the life of the defined contribution plan, the employer oversees the collection and investment of the funds connected with the fund.
Defined benefit plans of this nature often include the potential for employer matching contributions. That is, there is a cap on how much the employee can contribute to the plan during the course of a calendar year. The employer may match that amount with an equal contribution or at least contribute a fixed percentage of that capped amount. This process allows the employee to make regular contributions to the plan, while also gaining additional retirement security due to the contributions made by the employer.
The employer will manage the company retirement plan in some fashion. For smaller companies, a plan administrator may handle the defined contribution plan. Larger companies may choose to create a department or outsource the process to a firm that has expertise in the investment of funds collected for retirement plans. It is highly unusual for the employee to be actively involved in the administration of the plan, although this arrangement is possible.
Because a defined contribution plan sets specific limits and guidelines for the collection of contributions, the administration process is relatively straightforward. Employees can easily develop a good idea of how the plan works without making use of complicated formulas. Administrators also find the management process is often a matter of maintaining records using basic accounting principles, and exercising wisdom with investing the funds contributed to the plan. The sheer simplicity of the approach makes a defined contribution plan one of the most attractive retirement plans in use today.
While the contributions made to a defined contribution plan do not necessarily determine what type of payout the retired employee will eventually receive, some companies have used a model to ensure that the retiree will at least receive benefits equal to the amount of the employee contributions to the plan. This is often the case regardless of how well the investments perform. However, not every defined contribution plan is structured in this manner. For this reason, it is important for the employee to read and understand the terms and conditions that apply to the plan before making a decision to participate.