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A defined contribution plan is a common workplace retirement plan in which an employee contributes money and the employer typically makes a matching contribution. Two popular types of these plans are 401(k) and 403(b) plans. Defined contribution plans are the most widely used type of employer-sponsored benefit plans in the United States. The plan may require that you enroll yourself to take advantage.

A defined contribution (DC) plan is a type of retirement plan in which the employer, employee or both make contributions on a regular basis. Individual accounts are set up for participants and benefits are based on the amounts credited to these accounts (through employee contributions and, if applicable, employer contributions) plus any investment earnings on the money in the account. In defined contribution plans, future benefits fluctuate on the basis of investment earnings. The most common type of defined contribution plan is a savings and thrift plan. Under this type of plan, the employee contributes a predetermined portion of his or her earnings to an individual account, all or part of which is matched by the employer.

Defined contribution plans and defined benefit plans have a number of notable differences. In a defined contribution plan, both you and your employer can contribute to your individual account. For some plans, you may be required to wait up to one year before enrolling. There may also be a waiting period before any contributions your employer makes to the account become yours to keep.

In a defined benefit plan, generally only your employer contributes and you get a monthly payout in retirement. There are two types of defined benefit plans: Traditional pensions and cash-balance plans. Both plans automatically enroll participants. However, for some defined benefit plans, you must wait some period of time before you are enrolled and/or the benefits become yours to keep.

Defined-contribution plans accounted for $8.2 trillion of the $29.1 trillion in total retirement plan assets held in the United States as of June 19, 2019, according to the Investment Company Institute. The defined-contribution plan differs from a defined-benefit plan, also called a pension plan, which guarantees participants receive a certain benefit at a specific future date.

Defined contribution plans take pre-tax dollars and allow them to grow in capital market investments on a tax-deferred basis. This means that income tax will ultimately be paid on withdrawals, but not until retirement age (a minimum of 59½ years old, with required minimum distributions (RMDs) starting at age 72).

The idea is that employees earn more money, and thus are subject to a higher tax bracket as full-time workers, and will have a lower tax bracket when they are retired. Furthermore, the income that is earned inside the account is not subject to taxes until it is withdrawn by the account holder (if it’s withdrawn before age 59½, a 10% penalty will also apply, with certain exceptions).

Contributions made to a defined-contribution plan may be tax-deferred. In traditional defined-contribution plans, contributions are tax-deferred, but withdrawals are taxable. In the Roth 401(k), the account holder makes contributions after taxes, but withdrawals are tax-free if certain qualifications are met. The tax-advantaged status of defined-contribution plans generally allows balances to grow larger over time compared to accounts that are taxed every year, such as the income on investments held in brokerage accounts.

Employer-sponsored defined-contribution plans may also receive matching contributions. More than three-fourths of companies contribute to employee 401(k) accounts based on the amount the participant contributes. The most common employer matching contribution is 50 cents per $1 contributed up to a specified percentage, but some companies match $1 for every $1 contributed up to a percentage of an employee’s salary, generally 4%–6%. If your employer offers matching on your contributions, it is generally advisable to contribute at least the maximum amount they will match, as this is essentially free money that will grow over time and will benefit you in retirement.

India

Central Government employees in India who joined after January 1, 2004 participate in National Pension Scheme which is defined contribution plan run by Pension Fund Regulatory Authority of India. Earlier employees were under Defined Benefit Plan.

All Government and Private sector organizations had to offer Provident Fund (PF) which is a type of Defined Contribution Plan. The NPS which was started in 2004 is a recent option given to all Central Government employees. The 10% of contribution made by the employer and employees are mandated by the regulations. Additionally, employees are given the ability to opt for an additional contribution if they so desire. All contributions are managed by the PF authority. PF authority choose the investment vehicle; however, the beneficiaries are given a standard % of returns on their contribution. Some large private sector organizations have also formed their Trust to manage the contributions received from its employees.

United Kingdom

In the UK the shift from defined benefit to defined contribution retirement plans has elevated significantly, to the point where many large DB plans are no longer open to new employees. This momentum has been employer-driven and is considered a response to a combination of factors such as pension underfunding, declined long-term interest rates and the move to more market-based accounting. The focus is now on managing pension fund assets in relation to liabilities instead of market benchmarks. The Pensions Policy Institute estimates that in 2013 there were approximately 8 million private sector workers building up DC benefits, compared to approximately 1 million building up DB benefits. However, one point of concern with these schemes is that employers often contribute less than what they would under final salary plans. According to the National Association of Pension Funds (NAPF), employers contribute on average 11% of salary into final salary schemes, compared to only 6% to money purchase. This indicates that individuals will have to save more of their own income into a retirement fund in order to accomplish a satisfactory retirement income. Companies such as Aon Hewitt, Mercer and Aviva recognise these challenges and have identified the need to help new generations of workers with their retirement funding plans.

Budget 2014: All tax restrictions on retired people’s access to their registered retirement pots are removed, ending the requirement to buy an annuity. The taxable part of the registered retirement pot is taken as cash on retirement to be charged at normal income tax rates. The increase in total registered retirement savings that people can take as a lump sum to £30,000.

A defined-benefit plan is an employer-sponsored retirement plan where employee benefits are computed using a formula that considers several factors, such as length of employment and salary history.1 The company is responsible for managing the plan’s investments and risk and will usually hire an outside investment manager to do this. Typically, an employee cannot just withdraw funds as with a 401(k) plan. Rather they become eligible to take their benefit as a lifetime annuity or in some cases as a lumpsum at an age defined by the plan’s rules.

Planning for retirement is a crucial aspect of everybody’s lives. Considering the rising inflation level and limited social security initiatives for senior citizens, it is vital that you start planning your retirement early.

A defined benefit (DB) pension plan is a type of pension plan in which an employer/sponsor promises a specified pension payment, lump-sum or combination thereof on retirement that is predetermined by a formula based on the employee’s earnings history, tenure of service and age, rather than depending directly on individual investment returns. Traditionally, many governmental and public entities, as well as a large number of corporations, provide defined benefit plans, sometimes as a means of compensating workers in lieu of increased pay.

Pension or retirement plans offer the dual benefit of investment and insurance cover. By investing a certain amount regularly towards your pension plan, you will accumulate a considerable sum in a phase-by-phase manner. This will ensure a steady flow of funds once you retire.

Public Provident Fund is one of the most popular retirement planning schemes in India. When you start contributing to your retirement early, the funds build a secure golden year money-wise over the years. A well-chosen retirement plan can help you rise above inflation, thanks to the power of compounding.

A defined benefit plan is ‘defined‘ in the sense that the benefit formula is defined and known in advance. Conversely, for a “defined contribution retirement saving plan”, the formula for computing the employer’s and employee’s contributions is defined and known in advance, but the benefit to be paid out is not known in advance.

In the United States, 26 U.S.C. § 414(j) specifies a defined benefit plan to be any pension plan that is not a defined contribution plan, where a defined contribution plan is any plan with individual accounts. A traditional pension plan that defines a benefit for an employee upon that employee’s retirement is a defined benefit plan.

The most common type of formula used is based on the employee’s terminal earnings (final salary). Under this formula, benefits are based on a percentage of average earnings during a specified number of years at the end of a worker’s career.

In the private sector, defined benefit plans are often funded exclusively by employer contributions. In the public sector, defined benefit plans usually require employee contributions.

Over time, these plans may face deficits or surpluses between the money currently in the plans and the total amount of their pension obligations. Contributions may be made by the employee, the employer, or both. In many defined benefit plans, the employer bears the investment risk and can benefit from surpluses.

Benefit plan

Traditionally, retirement plans have been administered by institutions which exist specifically for that purpose, by large businesses, or, for government workers, by the government itself. A traditional form of a defined benefit plan is the final salary plan, under which the pension paid is equal to the number of years worked, multiplied by the member’s salary at retirement, multiplied by a factor known as the accrual rate. The final accrued amount is available as a monthly pension or a lump sum.

The benefit in a defined benefit pension plan is determined by a formula that can incorporate the employee’s pay, years of employment, age at retirement, and other factors. A simple example is a dollars times service plan design that provides a certain amount per month based on the time an employee works for a company. For example, a plan offering $100 a month per year of service would provide $3,000 per month to a retiree with 30 years of service. While this type of plan is popular among unionized workers, final average pay (FAP) remains the most common type of defined-benefit plan offered in the United States. In FAP plans, the average salary over the final years of an employee’s career determines the benefit amount.

Frequently, as in Canadian government employees’ pensions, the average salary uses current dollars. This results in inflation in the averaging years decreasing the cost and purchasing power of the pension. This can be avoided by converting salaries to dollars of the first year of retirement and then averaging. If that is done, then inflation has no direct effect on the purchasing power and cost of the pension at the outset.

In the United Kingdom, benefits are typically indexed for inflation (specifically the Consumer Price Index and previously the Retail Prices Index) as required by law for registered pension plans. Inflation during an employee’s retirement affects the purchasing power of the pension; the higher the inflation rate, the lower the purchasing power of a fixed annual pension. This effect can be mitigated by providing annual increases to the pension at the rate of inflation (usually capped, for instance at 5% in any given year). This method is advantageous for the employee, because it stabilizes the purchasing power of pensions to some extent.

If the pension plan allows for early retirement, payments are often reduced to recognize that the retirees will receive the payouts for longer periods of time. In the US, (under the ERISA rules), any reduction factor less than or equal to the actuarial early retirement reduction factor is acceptable.

Many DB plans include early retirement provisions to encourage employees to retire early, before the attainment of normal retirement age (usually age 65). Some of those provisions come in the form of additional temporary or supplemental benefits, which are payable to a certain age, usually before attaining normal retirement age.

Annuity vs. Lump-Sum Payments

Payment options commonly include a single-life annuity, which provides a fixed monthly benefit until death; a qualified joint and survivor annuity, which offers a fixed monthly benefit until death and allows the surviving spouse to continue receiving benefits thereafter; or a lump-sum payment, which pays the entire value of the plan in a single payment.

Working an additional year increases the employee’s benefits, as it increases the years of service used in the benefit formula. This extra year may also increase the final salary the employer uses to calculate the benefit. In addition, there may be a stipulation that says working past the plan’s normal retirement age automatically increases an employee’s benefits.

Net periodic pension cost is the cost of a pension plan for a reporting period, as stated in an employer’s financial statements. This cost includes the following components:

• Amortization of prior service cost or credit.
• Actual return on plan assets.
• Interest cost
• Service cost
• Gain or loss

Pension expense is the amount that a business charges to expense in relation to its liabilities for pensions payable to employees. The amount of this expense varies, depending upon whether the underlying pension is a defined benefit plan or a defined contribution plan. The characteristics of these plan types are as follows:

• Defined contribution plan. Under this plan, the employer’s entire obligation is complete once it has made a contribution payment into the plan, as long as no associated costs are being deferred for recognition in later periods. Thus, the employer commits to pay a specific amount of funds into a plan, but does not commit to the number of benefits subsequently distributed by that plan. The accounting for a defined contribution plan is to charge its contributions to expense as incurred.
• Defined benefit plan. Under this plan, the employer provides a predetermined periodic payment to employees after they retire. The amount of this future payment depends upon a number of future events, such as estimates of employee lifespan, how long current employees will continue to work for the company, and the pay level of employees just prior to their retirement. In essence, the accounting for defined benefit plans revolves around the estimation of the future payments to be made, and recognizing the related expense in the periods in which employees are rendering the services that qualify them to receive payments in the future under the terms of the plan.

Components of Company Pension Expense

1. Current Service Cost = amount by which a company’s defined benefit obligation increases as a result of employee service during the accounting period. The current service cost is fully and immediately recognized for the accounting period.
2. Interest Cost (same as the discount rate discussed later) = amount by which a company’s existing defined benefit obligation increases as a result of the passage of time. The interest cost is fully and immediately recognized for the accounting period.
3. Return on Plan Assets = Amount of returns generated by plan assets during the accounting period. Typically, companies apply EXPECTED return on plan assets when calculating pension expense. Long-term expected return will better reflect the plan’s investment strategy and reduce year to year volatility in the pension expense. The use of expected returns is allowed by GAAP and IFRS.  Since this is an asset return, the return on plan assets component acts as a contra expense, offsetting other costs.
4. Amortization of Past Service Cost = the difference in the DBO after a plan amendment has been adopted and the DBO before the plan amendment. The plan amendment could reduce costs, creating a benefit that reduces the pension expense.

• GAAP: this is recorded as a direct to equity adjustment outside of net income, as part of other comprehensive income for the accounting period in which the amendment took place. A periodic past service cost expense is then amortized to the pension expense over the remaining service lives of the employees covered by the amendment.
• IFRS: if the amendment affects any vested obligations, then the vested percentage of the past service cost is incorporated into the pension expense for the accounting period of the amendment and the remaining past service cost for unvested obligations is amortized to future pension expense calculations over the course of the related vesting period.

5. Amortization of Actuarial Gains and Losses.

Actuarial gains and losses arise from:

• Differences between expected plan returns and actual plan returns (see #2 of 5).
• Changes in actuarial assumptions that impact the current service cost (see #1 of 5). Examples: employee life expectancy, salary growth forecasts, interest cost component assumptions, retirement dates, etc.
• GAAP: actuarial gains and losses are recognized as part of other comprehensive income during the period of gain or loss, on the company’s statement of changes in shareholder’s equity.
• IFRS: actuarial gains and losses do not flow to equity, but are applied to assets or liabilities and are incorporated in the calculation of a net asset or liability on the balance sheet. A net pension asset is reported as pre-paid pension expense; a net liability is accrued pension expense.
• 10% Amortization Expense “Rule” companies will not begin to incorporate an amortization gain/loss into its calculation of pension expense until the gain/loss from asset return differences or the benefit/cost from changes to the plan exceeds the greater of 10% of the value of plan assets or 10% of the DBO.

Other post-employment benefits (OPEB) are the benefits, other than pension distributions, that employees may begin to receive from their employer once they retire. Other post-employment benefits can include life insurance, health insurance, and deferred compensation. These benefits are also referred to as “other post-retirement benefits.”

Postretirement benefits are various types of assistance given by an employer to its retirees. These benefits may be promised through a standard benefits package, or via a union agreement.

Businesses and other organizations that may provide benefits to employees after they retire include private sector companies; state, county, and municipal governments; and religious and educational institutions. Although these benefits are mostly employer-paid, retired employees may have to share a portion of the costs through copayments and deductibles, as well as making contributions to the plan back when they were still working. Labor unions may also provide other post-employment benefits to their members.

Examples of postretirement benefits are health insurance, legal services, life insurance, and a pension plan.

Life insurance

Like health insurance, the life insurance that employers may provide to retirees is typically part of a group plan and generally comes in the form of term life insurance.

Health coverage

Retiree health insurance is generally provided as part of a group plan, much as it probably was when the employee was still working. The group plan may be the same one offered to current employees, or it may be a separate plan just for retirees.

In many cases, if the retiree has enrolled in Medicare, the retiree coverage will be secondary. That is, Medicare will pay its portion of medical bills and the retiree coverage will pick up some part of the remainder. But terms can vary widely from plan to plan, so retirees should check their employer’s Summary Plan Description (SPD) for details.

Deferred compensation

Deferred-compensation arrangements, which are also considered a post-employment benefit, pay the employee a salary or lump sum at some predetermined time, typically after they retire. These plans come in two distinct types qualified and non-qualified but serve the same basic purpose, which is to defer taxes while the employee is still working and provide income in the future, ideally when that person is in a lower marginal tax bracket.

Other Post-Retirement Benefits and Compliance

The rules governing how companies report pension costs and obligations, as well as the disclosure of pension assets and obligations, are covered under Accounting Standards Codification Section 715 (ASC 715), formerly called the Statement of Financial Accounting Standards Nos. 87/88/158. The American Society of Pension Professionals & Actuaries (ASPPA) provides a guide on how to manage the ASC 715 process, which describes the disclosure information for a client’s financial reports, as well as lists the methodology used to complete the required actuarial calculations.

Other Post-Retirement Benefits and Cost

Direct contributions that pay for any post-employment benefits can expose an employer to certain risks and liabilities. For example, take the example of a former worker who is granted health insurance coverage at the cost/premium rates as current employees.

Typically, a retired worker will be older than the average current employee, and will, therefore, be more likely to incur higher medical expenses. There is also the potential that the health insurance coverage they are offered will not cover the costs of their care, possibly leaving gaps in coverage.

As with other forms of retirement compensation, other post-retirement benefits can come with stringent reporting requirements due to their costs to an organization, as well as for the overall return on investment compared to the value of the work employees have performed before retirement.

A projected benefit obligation (PBO) is an actuarial measurement of what a company will need at the present time to cover future pension liabilities. This measurement is used to determine how much must be paid into a defined benefit pension plan to satisfy all pension entitlements that have been earned by employees up to that date, adjusted for expected future salary increases.

A pension benefit obligation is the present value of retirement benefits earned by employees. The amount of this obligation is determined by an actuary, based on a number of assumptions, including the following:

• Estimated employee mortality rates
• Estimated future pay raises
• Estimated interest costs
• Estimated remaining employee service periods
• Amortization of actuarial gains or losses
• Amortization of prior service costs

Companies can provide employees with a number of benefits, including a salary, when they retire from work. The Financial Accounting Standards Board’s (FASB) Statement of Financial Accounting Standards No. 87 states that companies must measure and disclose their pension obligations, together with the performance of their plans, at the end of each accounting period. 

A projected benefit obligation (PBO) is one of three ways to calculate expenses or liabilities of traditional defined benefit pensions plans that take into account employee years of service and salary to calculate retirement benefits.

PBO assumes that the pension plan will not terminate in the foreseeable future and is adjusted to reflect expected compensation in the years ahead. As a result, it takes into account a number of factors, including the following:

• Assumed salary rises.
• The estimated remaining service life of employees.
• A forecast of employee mortality rates.

Actuaries are responsible for establishing whether pension plans are underfunded. These qualified professionals, who specialize in the measurement and management of risk and uncertainty, determine the benefits needed through a present value calculation.

Actuaries are responsible for comparing the pension plan’s liabilities to its assets. In general, they provide a breakdown of the following:

• Interest Costs: The annual interest accumulated on the unpaid balance of the PBO as an employee’s service time increases.
• Service costs: The increase in the present value of the defined benefit obligation, resulting from current employees getting another year’s credit for their service.
• Benefits paid: Obligations are reduced when benefits are paid out.
• Actuarial Gains or Losses: The difference between the pension payments made by an employer and the anticipated amount. A gain occurs if the amount paid is less than expected. A loss occurs if the amount paid is higher than expected.

PBO is one of the three approaches firms use to measure and disclose pension obligations. The other measures are:

Vested benefit obligations (VBO): The portion of the accumulated benefit obligation that employees will receive, irrespective of their continued participation in the company’s pension plan.

Accumulated benefit obligations (ABO): Unlike PBO, accumulated benefit obligations (ABO) refers to the present value of retirement benefits earned by employees using current compensation levels.

The assets of company pension plan also represent an important store of cash generating wealth, which under IAS 19 Employee Benefits are to be valued at fair value. These are, however, slightly different in that they do not (yet) appear directly in the balance sheet of the employer’s company but are offset against the pension obligation, and the net figure is shown. Plan assets occur when a company operates a defined benefit pension plan. This is a scheme where pensions are paid usually by reference to the employee’s salary when they retire or an average salary over a period. During employment, the employer company builds up a liability (pension obligation) for the amounts it will subsequently pay to the retired employee. This obligation is measured according to rules set out in the standard and is not at fair value as such.

The employer may put assets into a separate fund to meet the pension obligation. These assets, known as plan assets, are usually ring-fenced from the company and are not shown in the company balance sheet at present, even though some people think they should be. However, they do figure indirectly in the balance sheet because IAS 19 requires the employer to disclose the value of the pension obligation and the plan assets in the notes to the financial statements and then take the difference between the two  into the balance sheet.

Pension fund assets need to be prudently managed to ensure that retirees receive promised retirement benefits. For many years this meant that funds were limited to investing primarily in government securities, investment grade bonds, and bluechip stocks.

Changing market conditions and the need to maintain a high-enough rate of return have resulted in pension plan rules that allow investments in most asset classes. These are some of the most common investments to which pension funds allocate their substantial capital. Here, we take a look at some of the asset classes that pension funds are likely to own.

Inflation Protection

Inflation protection is a term used to refer to assets that tend to go up in value as inflation ramps up. These may include inflation adjusted bonds (e.g. TIPS), commodities, currencies, and interest-rate derivatives. The use of inflation adjusted bonds is often justified, but the increased allocation of pension fund assets in commodities, currencies, or derivatives has raised concerns by some due to the additional idiosyncratic risk that they carry.

Liability matching, also known as “immunization“, is an investment strategy that matches future assets sales and income streams against the timing of expected future expenses. The strategy has become widely embraced among pension fund managers, who attempt to minimize a portfolio’s liquidation risk by ensuring asset sales, interest, and dividend payments correspond with expected payments to pension recipients. This stands in contrast to simpler strategies that attempt to maximize return without regard to withdrawal timing.

Fixed Income Investments

U.S. Treasury securities and investment grade bonds are still a key part of pension fund portfolios. Investment managers seeking higher returns than what is available from conservative fixed-income instruments have expanded into high yield bonds and well secured commercial real estate loans. Portfolios including asset backed securities (ABS), such as student loans and credit-card debt, are increasing. However, the risk associated with those securities tends to be quite a bit greater than typical corporate or government bonds.

As an example of the prevalence of fixed-income securities in pension portfolios, the largest pension plan in the US the California Public Employees’ Retirement System (“CalPERS”), seeks an annual return of 7%,1 with approximately one-third of its $385.1 billion portfolio was allocated to fixed-income investments as of March 2020.

Private Equity

Institutional investors, such as pension funds, and those classified as accredited investors invest in private equity a long-term, alternative investment category suited for sophisticated investors. In fact, pension funds are one of the largest sources of capital for the private equity industry.

In its purest form, private equity represents managed pools of money invested in the equity of privately-held companies with the intention of eventually selling the investments for substantial gains. Private equity fund managers charge high fees based on promises of above-market returns.

Real Estate

Pension fund real estate investments are typically passive investments made through real estate investment trusts (REITs) or private equity pools. Some pension funds run real estate development departments to participate directly in the acquisition, development, or management of properties.

Long-term investments are in commercial real estate, such as office buildings, industrial parks, apartments, or retail complexes. The goal is to create a portfolio of properties that combine equity appreciation with a rising stream of inflation-adjusted income to balance the ups and downs of the markets.

Stocks

Equity investments in U.S. bluechip common and preferred stocks are a major investment class for pension funds.

Managers traditionally focus on dividends combined with growth. The search for higher returns has pushed some fund managers into riskier small-cap growth stocks and international equities.

Larger funds, such as CalPERS, self-manage their stock portfolios. Smaller funds are likely to seek outside management or else invest in institutional versions of the same mutual funds and exchange traded funds (ETFs) as individual investors. The prime difference here is that the institutional share classes do not have front-end sales commissions, redemption, or 12b-1 fees, and they charge a lower expense ratio.