Tuesday, September 07, 2010
Although Defined Contribution Plans have been around in various forms for decades, the form that most people are the familiar with is the 401(k) plan. So called since it is named after section 401(k) of the Internal Revenue Code. Similar, but slightly less familiar are the 403(b) and 457(b) plans related to employment in the nonprofit, state or local governments, and their agencies and organizations. Defined Contribution Plans are designed around the front-end “contributions” made into the plan rather than the benefit accrued on the back end of the plan. They are most typically funded through a combination of employer and employee periodic contributions over the employment period of an employee. While employee contributions may be matched with employer monies, it is possible to have plans where the only contributions come from either the employer or employee but not both. Contributions may be in the form of fixed dollar amounts or percentages of employee compensation. These plans work much like a personal savings account except monies are usually taken from the employee’s periodic payroll earnings on either before or after tax basis, and deposited into a segregated trust fund. The fund in overseen by a “trustee”, which could be a bank, investment brokerage firm or other financial institution. Monies are withdrawn at retirement or under special rules for certain and selective financial hardships.
Since Defined Contribution Plans define the contributions rather than the benefits of the plan, there is no guarantee that the accrued account balance available to the employee upon retirement will be any specific amount. However, Defined Benefits Plans guarantee that the employee will have a specific benefit available to them as defined by some formal benefit formula. With Defined Contribution Plans, the employee bears the full responsibility managing the account and funding it to the desired desired retirement level. While the employer may match some, all or none of the employee’s contributions, the employee must make up for any financial short falls due to poor market conditions or poor investment selections by the employee. With Defined Benefits Plans, if market conditions are unfavorable, or workforce demographics change, the employer is responsible for additional funding to maintain the “minimum funding” levels.
Oddly enough, many employees actually prefer Defined Contribution Plans to Defined Benefit Plans. One obvious reason is they are simple to understand, as in the earlier example of the savings plan model. Every payroll monies are deducted and deposited into the employee’s account, within a few days; the deposit can be viewed and verified. Most modern Defined Contribution Plans allow employees to go online, view and manage their accounts much like another investment account. Thus an employee can view their account balance daily and see the gains and losses accrue daily. While this is not recommended, it allows the employee to have a sense of control not experienced with Defined Benefit Plans.
Another reason why many employees preferred Defined Contribution Plans is portability of accounts whenever the employee separates from the employer. Most Defined Contribution Plans allow the employee to roll account balances into another plan, an IRA or other qualified retirement plans. This feature took on increased importance in the 1980’s and 1990’s as employee mobility increased. Unfortunately, many employees “cash-out” their Defined Contribution Plans when they leave their current employers. An October, 2009 report titled, “Those who cash out 401(k) plans are at risk” explained that a $5,000 account balance cashed out at age 25 would have a value close to $75,000 at retirement age. Since many 401(k) plan participants lack professional financial advice, they often make poor choices concerning their retirement planning. Even when professional advice is available, many fail to take advantage of such advice.
No comments:
Post a Comment