Retirement Basics: How do DC Plans Work?
Despite market volatility, most US employees contributing to retirement savings accounts continue to contribute on a regular basis to their plans, according to recent data released by leading investment and financial services firms in the US.
Retirement experts advise private and public sector workers, even if they are at the beginning of their careers, to start thinking about saving for retirement.
In a series of articles, we will present the key attributes of popular retirement plans.
There are two types of employer-sponsored retirement plans – defined benefit (‘DB’) plans and defined contribution (‘DC’) plans. DB plans provide a specified payment amount when the employee retires. In the case of DC plans, both employees and employers contribute over a period of time, and the funds are invested.
Over the last few decades, the transition from DB to DC plans as the primary workplace retirement offering, has gathered momentum in the US. Lower administrative costs and complexity, and greater workforce mobility have been cited as some of the main reasons for the shift.
A defined contribution or ‘DC’ plan is retirement plan in which an employee contributes a certain amount or a percentage of their salary to a retirement account. In the case of an employer-sponsored DC plan, the employer or plan sponsor will match a portion of the employee’s contribution.
There are restrictions on how and when employees can withdraw from these accounts.
According to the US Department of Labor website, in DC plans, “the employee or the employer (or both) contribute to the employee’s individual account under the plan, sometimes at a set rate, such as 5 percent of earnings annually.”
“These contributions generally are invested on the employee’s behalf. The employee will ultimately receive the balance in their account, which is based on contributions plus or minus investment gains or losses. The value of the account will fluctuate due to the changes in the value of the investments,” the site says. Examples of DC plans are 401(k) plans, 403(b) plans, employee stock ownership plans, and profit-sharing plans. To read our article on 401(k) plans, click here.
In the US, some of the most common DC plans include Individual Retirement Accounts (IRAs) and 401(k) plans. Such plans offer tax advantages for retirement savings.
These contributions are invested to earn interest, and the benefit that each employee gets from it depends on the return on those investments.
As the Internal Revenue Service or IRS website states: DC plans such as 401(k) and profit-sharing plans generally pay retirement benefits in a lump sum or in installments.
Eye on investment performance
A study conducted last year revealed that participants of DC plans are more comfortable with their current financial situation and ability to stay on track for retirement, compared to the previous year.
The Market Strategies International-Morpace Cogent ReportsTM DC Participant PlanscapeTM, July 2018 study also revealed that among other factors, investment performance “has the greatest influence on DC participant satisfaction with plan providers.”