Quiz 5: Overview of Defined Contribution Plan Types and Their Use in Comprehensive Retirement Plan Design
Defined Contribution plan refers to one of the method that involves fixed contribution on the part of employees and maximum contribution is made by the employee. The accumulated fund is then made available to the retired employee. This income is variable in nature. According to the Internal Revenue Code (IRC), it is allowed to collaborate benefits of the employers retirement plan with social security benefits available to the employee. After such collaboration, employer can make contribution in two levels- 1. Paying a specified fixed amount 2. Paying bit higher contribution above the fixed limit. However, this contribution cannot exceed a certain specified limit as per 401(I) which is known as permitted disparity. This disparity is usually adopted by employer to provide higher benefits to highly paid employees because of reduction in their social security benefit due to high pay. This disparity leads to removing discrepancy in benefits. However, this permitted disparity leads to limitation in the amount of excess contribution that can be made by the employer. The contribution can be made twice the contribution percentage where such percentage should not exceed 5.7% when the integration level is set at 20% of taxable income. When such level falls between 20 to 100%, this percentage falls from 5.7% to 5.4% in case of 20% to 80% integration further reduction leads the percentage fall at 4.3%. This clearly reflects the limitation of permitted disparity in employers contribution towards Defined Contribution Plan.
Pension plans are designed and provided by employer to its employee so as to secure their future by making available a particular income benefit even after retirement. This plan can be of two types- 1. Defined Benefit Plan Under this approach the contribution in the retirement plan is solely made by the employer which is made available to employees after retirement such that the whole cost of this benefit is borne by the employer. 2. Defined Contribution Plan This plan involves maximum contribution for future security by the employee themselves whereas employer makes a fixed contribution and the accumulated amount is provided as a benefit to the employee after retirement. Here the benefit is variable unlike benefit plan. The major difference between both the plans is the contribution of employees which is present in only defined contribution plan. Apart from this various characteristics that distinguishes contribution plan with benefit plan are- 1. In case of contribution plans, employer's contribution is made on the basis of employee's pay for total years served whereas age is not taken into account however in case of defined plan contribution was made under final pay on the basis of age and service period of the employee. 2. In contribution approach, the inflation rate and its effect on the investment and future is not taken into consideration by the employee however in case of benefit plan the employer takes care of such inflation for the retired employees by providing "ad-hoc" arrangements. 3. As per contribution approach, the risk and reward of investment is borne by the employees whereas in benefit approach employer bears them. 4. Also in case of benefit plan the contribution made by the employer and the cost incurred is variable so as to provide complete benefit to the employee however in contribution plan the contribution made and cost incurred by the employer remains fixed and the income/benefit of an employee remains variable depending upon the amount of fund accumulated. Thus, the following characteristics clearly state the difference present between both types of pension plans.
Pension plans are designed by employers to provide income benefit to their retirement benefit. One of the methods of pension plan includes Defined Contribution Plans. This approach involves fixed contribution to be made by the employer whereas employees are required to make maximum contribution and bear all the related risk and reward of investment. Defined Contribution Plans is highly accepted and serves as a major method for designing retirement plans. Contribution plans are highly efficient as it provides employers with the limited contribution policy reducing their cost of such plan also any related risks are borne by the employees reducing any further responsibility of the employer. It allows employees to make contribution for investment to secure their future and get regular income benefit after retirement. This plan efficiently helps the employer and employee to make contribution to secure retired employee's future needs. Its serves the means of retirement benefit plan for the employer by undertaking any of the available plans under conditional approach such as Stock ownership plan, profit sharing plan, money purchase pension plan etc. which would help in efficient designing of retirement plan by the employer.